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Posted by & filed under Economics & Markets, Wealth Management.

In the arena of academic finance, the debate overwhether a rebalancing “bonus” exists or not hasbecome somewhat of areligion!

Those who are ardentbelievers of an efficient market such as Nobel Prize winner Eugene Famausually believe all returnsshould be the result of taking risk and that simple actions like rebalancing periodically should not produce additional returns.

Those who believe the market is emotion-driven, such as Nobel Prize winner Robert Shiller, believe in a rebalancing “bonus”. Since the market is either over-priced or under-priced from time to time, rebalancing allows us to take advantage of this market mispricing.

The return differential of RSP vs SPY provides an excellent control experiment to test whether this illustrious rebalancing “bonus” actually exists. SPY and RSP invest in the same 500 largest stocks of the US. SPYbeing a cap-weighted fund, does not require rebalancing, while RSP being a equally weighted fund requires periodic rebalancing.

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Last week I wrote a post entitled Solving the Puzzle of S&P 500 Equally Weighted Index Outperformance.” The conclusion is that most of the outperformance is due to the additional risk taking of RSP. In both regressions, the alphas of RSP and SPY are both NOT significantly different from zero. So it appears Eugene Fama wins hands down.

But wait a minute! RSP has a positive alpha while SPY has a negative one. To dig deeper, I ran a regression of the return differentials over the three risk factors.

R(RSP) – R(SPY) = alpha_diff + beta1_diff*(Rmkt – rf) + beta2_diff*SML + beta3_diff*HML

I got the following:

Coefficients

Standard Error

T Stat

P-value

Alpha_diff

0.0341029

0.079318

0.42995

0.667988

Beta1_diff

0.09655527

0.021558

4.47893

1.7E-05

Beta2_diff

0.28696112

0.03905

7.34852

2.5E-11

Beta3_diff

0.11173843

0.035857

3.11621

0.002284

This basically confirms the conclusion of the previous post. That is, eventhough there is a huge return differential that is by and large accounted for by risk loadings (beta1, beta2 and beta3), the alpha differential is statistically insignificant.

However, it is not economically insignificant since the monthly alpha differential is 0.0341% and the annual differential is 0.41%. This is a material difference, consistent with other research which shows that arebalancing “bonus” is usually in the magnitude of 40 to 50 basis points.

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