A major advantage of resampled efficient optimization is that it provides financial advisors with a new approach to rebalancing, one that can greatly reduce trading costs and related operational problems. This new approach entails specifying an appropriate confidence interval bounding the efficient region, within which the advisor considers all portfolios at specific risk levels to be statistically indistinguishable from each other. Once the resampled efficient optimization is completed, it is then possible to determine the statistical equivalence of the existing and target portfolios. If they are significantly equivalent, rebalancing is unnecessary. If they are not equivalent, then rebalancing is necessary.
The availability of a rebalancing test gives financial advisors significant control over trading costs, and reduced trading costs mean higher returns for clients. While the prospective savings will depend on the width of the confidence interval, it is estimated that an approximately 60% reduction in trading costs is possible, on average.
Perhaps the greatest economy provided by the rebalancing test accrues to the advisor. An advisor responsible for 100 portfolios is required to spend, on average, at most 1% of his or her time analyzing each portfolio, irrespective of whether it needs rebalancing. With a simple computerized rebalancing test, he or she can scan all 100 portfolios and readily identify those that require further attention. Assuming that only 10 of the portfolios need to be rebalanced, the advisor then has the luxury of spending an average of 10% of his or her time on each. In other words, the advisor is able to direct his or her attention to those portfolios that need it and avoid those that don't. Such a system enables the advisor to provide equivalent oversight to client portfolios with less effort.
Conclusion
New developments in efficient asset allocation now provide financial advisors with valuable tools for estimating returns and optimizing and rebalancing portfolios. These developments, which promise to increase advisors' effectiveness and productivity, are based on the following:
1) The Resampled Efficient Region has rendered the concept of a deterministic Efficient Frontier obsolete for practical purposes.
2) It is advisable to adjust historical observations of return, volatility and covariance to produce usable forecasts of the performance of a wide range of asset allocations.
3) Proprietary forecasts (Bayesian estimates) of return, risk or covariance may significantly improve the performance of the asset-allocation process.
4) A new rebalancing test can significantly reduce trading costs, improve returns and strengthen the oversight function, while reducing the effort to administer it.
C. Michael Carty is Principal and Chief Investment Officer for New Millennium Advisors, Inc., a New York City-based investment advisor. He can be reached at [email protected].