It's an open secret in this need-for-speed era on Wall Street: Investors, who adjust their stock-bond portfolios like clockwork on regular schedules, are at the mercy of front-running by fast-money speculators.
Now, a group of academics claim they've put a price tag on the resulting cost to pension funds and other market participants known for their rebalancing activity: $16 billion a year.
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Mechanical buying and selling by institutions to hold the mix of assets steady over time comes with a quantifiable downside, say researchers including Campbell Harvey of Duke University in a paper called The Unintended Consequences of Rebalancing. Much of it is the result of opportunistic competitors anticipating the trades and swooping in first, moving prices, they said.
While a drag on returns, time-honored processes for keeping stock and bond allocations in check serve an important purpose and have no obvious alternative, the paper concedes. Whatever the case it's a bounty for hedge funds and other speculators, who have figured out how to exploit rebalancing patterns, whether it's monthly or quarterly, to ring up lucrative returns along the way.
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"Think of it in simple terms. The pension needs to buy and the price is 100," Harvey wrote in an e-mail. "The front runners increase the price to 100-plus-something. Hence, the pension gets a worse deal."
The study is the latest to shine light on popular diversification strategies that guide trillions of dollars of investment capital around the world, including the famous 60/40 mix between stocks and bonds. Rebalancing to tamp down the influence of a surging asset class has also become an urgent matter, after stocks trounced Treasuries for three straight years.
Rather than trace the individual impact for thousands of funds, the authors built models based on rules that big institutions are known to use when rebalancing, controlling the experiment for a host of potential influences. When the model showed managers were, say, likely to be selling equities whose portfolio weights had gotten too big, they found a statistically significant reduction in stocks' return over the next few days — "price impact" that they say is at least partially ascribable to front-running.
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Indeed, a theoretical portfolio designed to anticipate adjustments by big institutions returned 9.9% annually, they found.
To quantify the cost borne by funds and their investors, they simulated rebalancing trades for a 60/40 portfolio of the S&P 500 and 10-year Treasury notes, using daily returns in futures during the 1997-2023 period. Based on their estimated price impact and the portfolio's weight deviations from the target, the test spat out a "conservative" estimate on the financial hit to Americans: More than 8 basis points a year for the $20 trillion US retirement industry, which translates to $200 per households.
Mechanical rebalancing "induces potentially unnecessary costs, thereby harming investors," they wrote.
It's common knowledge that pensions, sovereign wealth and mutual funds — those adopting a preset asset allocation approach — need to adjust holdings when their portfolios digress from the target levels as a result of market swings. Wall Street strategists, from the likes of Goldman Sachs Group and JPMorgan Chase, have models to track flows to and from such funds and regularly try to predict their market impact.
The paper, whose authors also include Michele Mazzoleni, a researcher at Capital Group, and Alessandro Melone, assistant professor of finance at Ohio State University, acknowledges that fixing the problem isn't easy. Harvey — who is known for his pioneering work on the yield curve as an economic bellwether, among other things — and his colleagues said they discussed their findings with pension managers and the like. The academics found that these investors knew about the front-running risk but took few steps to guard against it, citing the difficulty of getting investment committees to make changes in rebalancing policies.
While a cost-mitigating strategy that avoids pre-scheduled rebalancing is possible in theory, the researchers said, a practical solution requires broader considerations, given the involvement of players like index managers during the process.
"Rebalancing is a coordination exercise," they wrote. "The actions of individual rebalancers could impact the decisions of other rebalancers, while the actions of liquidity providers and other sophisticated investors could further influence strategy designs. Furthermore, agency problems should not be ignored, as the design of benchmarks appears to play an important role in informing rebalancing decisions."
