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This short article investigates the rebalancing premium that investors may expect from risk parity portfolios1. It is offered as an appendix to the paper, “Risk Parity: Methods and Measures of Success”.

I define rebalancing premium as the difference between the compound return on a portfolio, and the weighted average compound returns produced by the underlying investments in a portfolio.

I examine the distribution of rebalancing premiums for a simple risk parity implementation (a version of the Permanent Portfolio) consisting of US stocks, gold and bonds from 1982 through May 2020. I then proceed to analyze historical and expected future rebalancing premia for a variety of global risk parity strategies composed of 64 futures markets from June 1985 through May 2020.

When applied to the three markets in the Permanent Portfolio I surface a rebalancing premium of approximately 1.2% per year. The most diversified risk parity portfolios produced a rebalancing premium of more than 3% per year.

In the current low return environment, a diversified risk parity portfolio with a 2-3% rebalancing premium may represent an attractive alternative to global 60/40, with the added benefit of owning a diverse set of markets that benefit from a wider range of economic outcomes.

Introduction

When scaled to the same volatility as S&P 500 futures2, the compound excess returns on S&P 500, gold, and 10-year Treasury futures from June 1982 through September 2020 were 7.2%, 0.6%, and 12.4%, respectively.

One might expect that a portfolio that preserved a one-third allocation by regularly rebalancing back to target weights would have produced a return equal to the average of their constituent compound returns: 6.74%. In fact, a strategy that rebalanced at the end of each month to preserve equal risk weighting produced a compound return of 7.93, a full 1.19% per year higher than the average of the three.

This effect is referred to variously as the “rebalancing premium,” “volatility harvesting,” “volatility pumping,” or “gamma scalping.” It emerges mechanically from the process of continuously selling uncorrelated assets with gains to purchase assets with losses (and vice versa) from period to period.