Asset Allocation | Equities | Global | Rates | UK
Will Rebalancing Flows Support Month-End Equities?
- By Henry Occleston
- 4 min read
Summary
- Large real-money investors often target particular asset ratios (e.g., bonds/equities).
- When one asset greatly outperforms another it may necessitate a rebalancing.
- Such rebalancing should, in theory, mean relative gains for the underperforming asset.
- The last eight days of the quarter is when the QTD performance is most likely to reverse (suggesting rebalancing).
Market Implications
- Recent relative bond/equity performance does not suggest significant supportive flows for equities across the US and Eurozone.
- Relative FTSE performance suggest a negative effect from rebalancing into month-end.
- Relative Nikkei performance suggests a positive effect from rebalancing into month-end.
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Summary
- Large real-money investors often target particular asset ratios (e.g., bonds/equities).
- When one asset greatly outperforms another it may necessitate a rebalancing.
- Such rebalancing should, in theory, mean relative gains for the underperforming asset.
- The last eight days of the quarter is when the QTD performance is most likely to reverse (suggesting rebalancing).
Market Implications
- Recent relative bond/equity performance does not suggest significant supportive flows for equities across the US and Eurozone.
- Relative FTSE performance suggest a negative effect from rebalancing into month-end.
- Relative Nikkei performance suggests a positive effect from rebalancing into month-end.
Rebalancing in Theory
The 60/40 strategy is a well-documented cliché in finance. The idea is that large real-money investors allocate roughly 60% of a portfolio to equities and 40% to fixed income. In the US at least, that has not been true for some time. But such investors still target certain proportions with deviation limits (for instance, Japan’s ¥191tn GPIF).
This means that when the respective asset classes see large market moves, investors may need to rebalance. Chart 1 illustrates this very simply. Here, a fund sticks closely to a 40% bond and 60% equity mix. Over period T1, equities gain 10% while bonds lose 10%, creating the need to buy 4.8 units of bonds and sell 4.8 units of equities at the rebalance.
In theory, this rebalancing flow provides a boost to bond demand and equity supply in the market. All else equal, this means supported bond prices and suppressed equity prices. Therefore, when an asset has underperformed over a period before rebalancing, you might expect it to outperform in the period when rebalancing occurs.
The Effect in Reality
The real world is unfortunately more complex than this. FX translation effects, allocations to other asset classes (hedge funds, real estate etc.), tolerance bands, and pre-emptive rebalancing through the period will all suppress this effect.
That is not to say the effect is zero. Flows tend to rebalance towards the ends of periods, and we are approaching several. The next two weeks will see a month-end, quarter-end, and (for Japan, Canada, Singapore and the UK) a fiscal year-end.
Quarter-to-date (QTD), asset performance has been poor for both equities and fixed income. EuroStoxx and Nikkei had the greatest negative returns, and the FTSE All Share had the least (Chart 2). As per our simple, indicative rebalancing example, the relative equity/bond performance should be most important. There, we see that equities in Japan and the Eurozone (EZ) have underperformed their respective sovereign bonds most, while the FTSE has outperformed gilts.
When Does Rebalancing Happen?
The period of rebalancing (when companies begin buying the underperformer of the quarter) is unclear. It likely varies widely by investor and country. We can attempt to approximate it by taking the point at which the correlation between the QTD and the rest-of-quarter (RoQ) performance is most negative (Chart 3).
That point is eight days before quarter-end for the UK, EZ, and US, and 10 days before quarter-end for Japan. Therefore, much of this quarter’s rebalancing should happen over the next week.
Implications for Flows Out to the End of March
We examine correlations between relative equity and bond performance in the final eight days of the month and quarter versus the MTD and QTD performance. We find that larger magnitude performance differentials between stocks and bonds are more likely to trigger reversals of performance into the end of the period (as you would expect from rebalancing).
More tellingly, we find that the effect is historically strongest in the UK. There, both MTD and QTD performance suggests rebalancing flows that will favour bonds over equities (Charts 4 and 5).
Neither the US nor EZ has seen a disparity in equity/bond performance large enough to suggest significant rebalancing. Meanwhile, Japan MTD moves appear large enough to drive rebalancing flows to support Nikkei outperformance vs JGBs (Chart 6).
Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)