Low-Risk Benchmarking Transcends Rebalancing Methods

Abstract

The dismal performance of managed investment and the success of equal allocation and minimum variance models prompt these questions: Can rebalancing driven by minimum variance and maximum diversification rebalancing outperform naive models? Can a minimum variance model produce higher risk-adjusted returns than a maximum diversification model when security selection favors low-correlated assets? This study uses expected shortfall to measure risk, bootstrapping to transform fat-tailed distributions so they are suitable for t-tests, and factor analysis to help explain the relative performance of the models. The minimum variance and maximum diversification models outperformed naive models, and the minimum variance models produced higher risk-adjusted returns than the maximum diversification model. Market factors adequately explained differences in returns between rebalancing models, but adding a factor for the effect of rebalancing procedures improved all models. All models constrained by the lower risk benchmark produced higher risk-adjusted returns than corresponding models constrained by the higher risk benchmark. This outcome suggests many rebalancing models—perhaps even return-based models—could produce superior risk-adjusted returns if lower risk benchmarks constrain risk. TOPICS:Portfolio theory, portfolio construction, risk management, factor-based models, exchange-traded funds and applications Key Findings ▪ The two minimum variance models produced statistically significant superior risk-adjusted returns. ▪ All models constrained by the lower risk benchmark produced higher risk-adjusted returns than corresponding models constrained by the higher risk benchmark. ▪ Although market factors explained differences in model returns, adjusted R2 values increased when regression models included a rebalancing factor.