Volatility Lightning Strike

When Volatility Strikes, a Disciplined Path to Portfolio Rebalancing


A little volatility can create a lot of upheaval. And if you were caught off guard during the market’s dizzying gyrations in recent months, you weren’t alone. The thing about volatility is that it’s next to impossible to predict when it will strike. So how can you be better prepared for when it does? And how can you keep portfolio exposures on target through the turbulence? By introducing a system of disciplined, rules-based portfolio rebalancing.

Periods of high volatility create opportunities for investors to add value through portfolio rebalancing, yet many face challenges in implementing a disciplined and responsive rebalancing strategy. Fortunately, policy-based overlay management can help improve the rebalancing process during challenging times.

The problem with traditional portfolio rebalancing strategies

Investors who rely on traditional rebalancing programs often struggle to react to outsize market moves in a timely and efficient manner. Several factors delay investors from identifying and acting on rebalance triggers, including:

  • A lack of consolidated current portfolio values
  • An onerous formal decision-making and approval process
  • Behavioral bias in determining the “right time” to trade

Once approval is obtained, coordinating with multiple managers to buy and sell physical securities, funds, or both can be time consuming and expensive—and may result in exposure gaps during the transition of assets.

Advantages of disciplined rebalancing through a policy-based overlay

Rebalancing through an overlay introduces daily monitoring, which allows for the timely identification of and response to portfolio imbalances—including same day realignment of portfolio exposures. It can also help reduce transaction costs and improve policy benchmark tracking. 

How does the daily process work? After portfolio imbalances exceed predetermined thresholds, the overlay manager brings asset class exposures back to the policy target by simultaneously purchasing and selling exchange-traded futures or exchange-traded funds rather than coordinating purchases and sales of the investor’s individual holdings. Using an overlay program to implement a disciplined rebalancing program is cost efficient, reduces behavioral biases, and forces the discipline of buying low and selling high.

Rebalancing and volatility: a recent example

The return of volatility in the first quarter of 2018 is a prime example of how short-term volatility can result in a rebalancing opportunity. During the first several weeks of January, the equity market advanced sharply, producing a quarter-to-date S&P 500® Index return of 7.5% through January 26. The index subsequently retreated over 10% lower the following couple of weeks. The balance of the quarter saw several other sharp market advances and pullbacks while finishing modestly down by 0.8%. While the equity market was relatively flat for the quarter, rebalancing through an overlay strategy allowed institutional investors to capture incremental return that may not have been possible with a less responsive, traditional procedure.

The bottom line

Large spikes and deep declines in rapid succession can be uncomfortable, but they don’t have to be damaging. With the right system in place, you can harvest returns from the tumult—and turn volatility into opportunity.

Potential Parametric solution

Our Overlay Solutions are a collection of comprehensive custom overlay that seeks to achieve an investor’s policy objectives related to exposure management and cash securitization while helping minimize transaction costs. It includes a rebalancing of fund exposures in an efficient and cost-effective manner back to the desired allocation.

Justin Henne

Justin Henne, CFA, Managing Director, Customized Exposure Management

Justin leads the investment team responsible for the implementation and enhancement of Parametric’s Customized Exposure Management Strategy. Since joining Parametric in 2004 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Justin has gained extensive experience trading a wide variety of derivative instruments to meet each client’s unique exposure and risk management objectives. He earned a BA in financial management from the University of St. Thomas. A CFA charterholder, Justin is a member of the CFA Society of Minnesota.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.