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Optimal Asset Rebalancing in the Presence of Transactions Costs

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  • Hayne Leland.

Abstract

We examine the optimal trading strategy for an investment fund which wishes to maintain two assets in fixed proportions, e.g. 60/40 in stocks and bonds. Transactions costs are assumed to be proportional to the amount of each asset traded. We show that the optimal policy involves a band about the target stock proportion. As long as the actual stock/bond ratio remains inside this band, no trading should occur. If the ratio goes outside the band, trading should be undertaken to move the ratio to the nearest edge of the band. We compute the optimal band and resulting annual turnover and tracking error of the optimal policy, as a function of transactions costs, asset volatility, the target asset mix, and other parameters. We show how changes in transactions costs and other parameters affect the size of the no-trade band, turnover, and tracking error. Compared to a quarterly rebalancing strategy an example demonstrates that the optimal strategy can reduce turnover by almost 50 percent.
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Suggested Citation

  • Hayne Leland., 1996. "Optimal Asset Rebalancing in the Presence of Transactions Costs," Research Program in Finance Working Papers RPF-261, University of California at Berkeley.
    • Handle: RePEc:ucb:calbrf:rpf-261
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    Cited by:

    1. Samuel Kyle Jones & Joe Bert Stine, 2010. "Expected utility and the non-normal returns of common portfolio rebalancing strategies," Journal of Asset Management, Palgrave Macmillan, vol. 10(6), pages 406-419, February.
    2. Levy, Moshe, 2024. "Does constant asset allocation dominate buy-and-hold?," Finance Research Letters, Elsevier, vol. 62(PB).
    3. Hiroatsu Tanaka & Naohiko Baba, 2003. "Optimal Timing in Trading Japanese Equity Mutual Funds: Theory and Evidence," Bank of Japan Working Paper Series 03-E-2, Bank of Japan.
    4. Andrew Ang & Morten Sorensen, 2012. "Risks, Returns, and Optimal Holdings of Private Equity: A Survey of Existing Approaches," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 2(03), pages 1-27.
    5. Gandolfi, G. & Sabatini, A. & Rossolini, M., 2007. "PID feedback controller used as a tactical asset allocation technique: The G.A.M. model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 383(1), pages 71-78.
    6. Hibiki Norio & Yamamoto Rei, 2014. "Optimal Symmetric No-Trade Ranges in Asset Rebalancing Strategy with Transaction Costs: An Application to the Government Pension Investment Fund in Japan," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 8(2), pages 293-327, July.
    7. Haim Levy, 2025. "To revise or not to revise? This is the question," Annals of Operations Research, Springer, vol. 346(1), pages 157-179, March.

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