Maximizing the Rebalancing Premium: Why Risk Parity portfolios are much greater than the sum of their parts
This short article investigates the rebalancing premium that investors may expect from risk parity portfolios¹. It is offered as an appendix to the paper, “Risk Parity: Methods and Measures of Success”.
We define rebalancing premium as the difference between the compound return on a portfolio, and the weighted average compound returns produced by the underlying investments in a portfolio.
We examine the distribution of rebalancing premiums for a simple risk parity implementation (a version of the Permanent Portfolio) consisting of US stocks, gold and bonds from 1982 through May 2020. We then proceed to analyze historical and expected future rebalancing premia for a variety of global risk parity strategies composed of 64 futures markets from June 1985 through May 2020.
When applied to the three markets in the Permanent Portfolio we surface a rebalancing premium of approximately 1.2 percent per year. The most diversified risk parity portfolios produced a rebalancing premium of more than 3 percent per year.
In the current low return environment, a diversified risk parity portfolio with a 2-3 percent rebalancing premium may represent an attractive alternative to global 60/40, with the added benefit of owning a diverse set of markets that benefit from a wider range of economic outcomes.
¹ This paper is not intended to be a comprehensive analytical treatment on stochastic portfolio theory and the mathematics of rebalancing. Readers who are interested in more comprehensive treatments and proofs are invited to read “Stochastic Portfolio Theory” by Fernholz, “The Ex-Ante Rebalancing Premium” by Hillion and “Demystifying Rebalancing Premium: A Methodological Path to Risk Premia Engineering” by Dubikovsky and Susinno.