During the financial crisis, plan sponsors learned at least three important lessons learned about asset mix rebalancing.
The first and most important lesson was that rebalancing works – it is a time-tested method that can add significantly to total portfolio returns and risk management. Rebalancing forces you to buy equities when it is very uncomfortable (the news flow is terrible and the sentiment is that equities will continue to fall) and sell equities when it is psychologically and politically difficult to do so (the news is great, the economy is great, profits are great, sentiment is overwhelmingly positive).
Being contrarian is difficult and looks like it should have been easy after the fact. But putting in large buy orders for equities in February 2009 and watching the equity market continue to slide lower and lower was mentally punishing for plan sponsors. It involved a lot of second guessing.
Then market sentiment suddenly changed and on March 9th — 2009 equities began a rally of approximately 40% over two months.
The second lesson is that rebalancing needs to walk a fine line between mechanical procedure and professional judgment. It should be both art and science. The mechanical targets force doing something but professional judgment is also necessary as the conditions are unique in every situation and there are other considerations, most obvious through this cycle was liquidity and the potential cost of blindly forcing fixed income managers to sell credit into the cash market that had very limited liquidity and would have been very expensive to transact in.
Judgment was also necessary because of the extreme volatility and the severity of the drop in values.
A blind, mechanical process that could execute quickly, perhaps with futures contracts, would have made continuous purchases of equities right through September, October and November resulting in increased losses compared to a static strategy.
The third rebalancing lesson is that the ability to rebalance using derivatives (futures and currency forward contracts) is essential for all mid- to large-sized funds. With limited liquidity in the fixed income market, a derivatives overlay allows for rebalancing with simplicity and at a low cost. Without this ability, the choices are to do nothing or force an expensive liquidation into an illiquid cash market.
Both alternatives were expensive and sub-optimal.