There is a discussion on rebalancing asset class weight in reading 12. Why does an asset class with a higher correlation with the rest of the portfolio justify a wider rebalancing range compared to an asset class with a lower correlation.
I am thinking that it is because the higher correlation will cause larger swings in the portfolio’s value, and it would lead to frequent rebalancing if the rebalancing range was tight. Is that correct?
@Hardik_Parikh, I remember getting confused with this too, as it’s pretty counterintuitive.
When there is high correlation between an asset class with the rest of the portfolio, this means that the returns tend to move together. While that is riskier, there is less risk for the asset allocation as a percentage to deviate from what investors choose it to be. Therefore risk tolerance is higher and a wider corridor is acceptable.
In other words, highly correlated assets’ target weights/allocations stay roughly the same since everything is moving together. This implies there is less deviation from the target weights and thus you can have a wider corridor before rebalancing.
So using an extreme example, if you have 2 asset classes that are perfectly correlated, when one goes up, the other will follow. Thus, weighting of the 2 asset classes will remain similar since they both moved in the same direction.
Just to add some stuff from my notes:
3 factors positively-correlated with corridor:
- higher transaction costs
- higher risk tolerance
- high positive correlation with other asset classes (no need to rebalance if they move up/down together)
2 factors negatively-correlated with corridor:
- high volatility of the asset class;
- high volatilities of the other asset classes (highly volatile asset class means increasing risk, so you can set narrower ranges to control that risk)
Hope these makes sense?
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