A heavier weighting in value and small-cap equities explains some of return advantage of the equal-weighted indexes, which is a natural byproduct of maintaining an even mix in everything. But some of the higher return is directly related to the rebalancing, which is a formulaic strategy that's intent on buying low and selling high.

Rebalancing is also recognized as a factor in the outperformance of other equity indices with alternative weighting strategies, such as Research Affiliates' Fundamental Index strategy, which is the basis for a variety of ETFs and index mutual funds. The oldest is the PowerShares FTSE RAFI US 1000 (PRF), which weights the largest 1,000 U.S. stocks based on their "economic footprint" rather than market capitalization. Since the ETF's launch in December 2005, it has posted an annualized 1.4% total return against an annualized 0.5% loss in the iShares Russell 1000 (IWB), an ETF that also holds the largest 1,000 U.S. stocks but is cap-weighted.

What accounts for the higher performance in the fundamentally weighted ETF? Research Affiliates emphasizes its proprietary index design, but acknowledges that rebalancing is indeed one of the factors boosting return. "Rebalancing is a relatively inexpensive way of capturing added value," advised the October 2009 edition of the firm's newsletter Fundamental Index.

That's hardly a revelation once you recognize that rebalancing can mint a gain from a collection of assets that would otherwise suffer losses by themselves. In an article published earlier this year, Michael Stutzer, a finance professor at the University of Colorado, demonstrated mathematically how rebalancing two assets that log negative cumulative returns by themselves can generate an overall gain when they're held together in a portfolio (the argument appears in his article "The Paradox of Diversification," The Journal of Investing, Spring 2010).

The message is that asset allocation and rebalancing are more powerful when you use them together. Yes, diversifying within an asset class or across asset classes is a savvy move. But such a portfolio left untended can build up high risk concentrations of winning securities and asset classes-a risk that the history of mean reversion suggests may go unrewarded for long periods. Rebalancing helps minimize that hazard. As Stutzer told me in an interview, rebalancing "improves your median return by lowering your volatility."

Higher return with less volatility? Isn't that a violation of finance theory? Not necessarily. Remember, modern portfolio theory says higher return only comes by way of higher risk (classically defined as higher return volatility). But this is true only in the original reading of the theory, analyzing one period. In this simplified world, you set the allocation once and let it ride.
Accordingly, if you design a portfolio today and leave it untouched for the next ten years, much of the gain (or loss) will be influenced by the original allocation. But introducing rebalancing throughout the same decade-long period can change the risk-return relationship.

"It's somewhat counterintuitive," Stutzer says. People tend to think that lower volatility must bring lower return, but that's not necessarily true over multiple periods, he explains.

Multi-Period Analysis
It's old hat in the 21st century to study the finer points of multiple investment periods. The concept of rebalancing through time has been around since the early 1970s, when Nobel prize-winning economist Robert Merton formally explored the idea.

Imagine an asset whose expected return is negatively correlated with the current yield on the ten-year Treasury note. Under the classic reading of modern portfolio theory, this dynamic relationship is relevant only once-during the initial creation of the portfolio. By contrast, an investor who plans on rebalancing (an "intertemporal maximizer," in the forbidding argot of economics) will continually evaluate this negative correlation and perhaps adjust the asset allocation. In other words, the investor anticipates higher returns when yields fall, and vice versa, and acts accordingly.

There are still risks in rebalancing and otherwise dynamically managing asset allocation. Perhaps the main challenge is timing. Deciding when to rebalance can be as important as how to rebalance, especially in the short term.