State Street Associates (SSA) has developed an algorithm-based portfolio rebalancing system that aims to surpass calendar-based and tolerance band rebalancing, the two most common methods.

Optimal Rebalancing Services (ORS), which has been purpose-built for institutional investors, applies a recursive algorithm similar to those developed in control theory, which is used to program robots. ORS aims to minimise rebalancing costs while maintaining “optimal” asset allocation, Simon Myrgren, vice president of the Boston-based SSA, said. Once the algorithm has been applied to an investor’s asset allocation, a ‘roadmap’ is generated, which is effectively “a database of optimal choices based upon the asset allocation,” Myrgren said. The roadmap devises a set of rebalancing rules to be applied throughout a given time horizon. It canvasses billions of possible portfolio weights for a given allocation, aiming to identify astute future changes that could be made to the portfolio, and suggests points at which rebalancing might be required. Once set up, ORS runs as an ‘autopilot’ system. However, if an investor changes their asset allocation, the process must begin anew. To rebalance a portfolio, ORS uses futures trades, keeping physical portfolios in the market and helping to reducing transaction costs. “We take the data, run the algorithm and generate the roadmap. We then send clients an access database file, and they access the roadmap through that,”; Myrgren said. The tool is currently offered as a value-add to State Street Global Markets clients, although implementation costs apply when futures trades are enacted, James Woodward, State Street vice president transition manager and securities trading, said. The two most conventional rebalancing methods are calendar-based, where investors rebalance allocations at arbitrary weekly, monthly, quarterly or annual intervals, and tolerance band, where rebalancing is triggered to a set percentage of portfolio drift, usually between 3 and 5 per cent. SSA has calculated that for an allocation involving five assets, the ORS system makes a saving of $745,000, or 19 per cent, when compared with a 2 per cent tolerance band system. For an allocation containing 100 assets rebalanced on a semi-annual calendar basis, ORS would save $4,545,000, or 55 per cent, in rebalancing costs. Myrgren said ORS has several users in Europe and North America, mostly pension funds. SSA is an academic research partnership with State Street Global Markets (SSGM).

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