Optimal Rebalancing Strategy Using Dynamic Programming for Institutional Portfolios
Author | : Walter Sun |
Publisher | : |
Total Pages | : 25 |
Release | : 2005 |
ISBN-10 | : OCLC:1290347341 |
ISBN-13 | : |
Rating | : 4/5 (41 Downloads) |
Book excerpt: Institutional fund managers generally rebalance using ad hoc methods such as calendar basis or tolerance band triggers. We propose a different framework that quantifies the cost of a rebalancing strategy in terms of risk-adjusted returns net of transaction costs. We then develop an optimal rebalancing strategy that actively seeks to minimize that cost. We use certainty equivalents and the transaction costs associated with a policy to define a cost-to-go function, and we minimize this expected cost-to-go using dynamic programming. We apply Monte Carlo simulations to demonstrate that our method outperforms traditional rebalancing strategies like monthly, quarterly, annual, and 5% tolerance rebalancing. We also show the robustness of our method to model error by performing sensitivity analyses.