Rebalancing with transaction costs: theory, simulations, and actual data

Abstract

In the absence of transaction costs and the presence of independent returns, a buy-and-hold strategy theoretically generates higher expected returns than a fixed-weight strategy, where the portfolio weights are regularly readjusted/rebalanced to some initial level. This higher expected return comes with higher volatility. The resulting trade-off leads to different rankings of the Sharpe ratio depending on the statistical moments of the assets. We also focus on Maximum Drawdown. We theoretically discuss causes affecting the ranking of the Sharpe ratio, and we introduce an easy-to-implement methodology to deal with proportional transaction costs. Under transaction costs, the buy-and-hold strategy as the cheaper approach should be the winner. In various simulation experiments, we investigate the relevance of transaction costs on rebalancing strategies. Eventually, we consider several realistic portfolios with a risk-free asset, bonds, stock indices, commodities and real estate that allow us to demonstrate that in practice rebalancing has value.