By David Swensen, Chief Investment Officer, Yale University

(Editor's Note: The large university endowments have compiled an enviable record of investment success. Two of the most notable are Harvard and Yale. In this article, David Swensen, who steers Yale's endowment, addresses the importance of real-time rebalancing. And though the example is his first-hand experience at Yale, Swensen makes the point that the underlying need for frequent allocation rebalancing is any investor's ticket to reduced risk and enhanced return).

Frequent rebalancing activity allows investors to maintain a consistent risk profile and to exploit return-generating opportunities created by excess security price volatility. Moreover, real-time rebalancing tends to cost less, as trades generally prove accommodating to the market.

Frequent rebalancers buy in the face of immediate declines and sell in the face of immediate increases, in both cases supplying liquidity for traders pursuing the opposite, predominant tack.

Benefits of Rebalancing a Portfolio

Although few investors commit the time and resources necessary to conduct real-time rebalancing, an examination of the benefits of intensive rebalancing provides a context for understanding the value of the strategy.

Consider Yale University's rebalancing activity. Yale possesses a number of advantages unavailable to most investors. The university's endowment enjoys tax-exempt status, allowing frequent trading without adverse tax consequences associated with realization of gains.

A sophisticated team of investment professionals manages the fund on a day-to-day basis, providing the staff support needed for management-intensive activities. Yale's special tax status and dedicated investment staff permit the university to engage in real-time rebalancing activity.

Yale's trading activity during the fiscal year ending June 30, 2003, provides some insight into the potential magnitude of rebalancing profits. During the year, the U.S. equity market, as measured by the Wilshire 5000, produced a total return of 1.3 percent. Investors undertaking an annual review of portfolio allocations would likely do little to rebalance domestic equity holdings (unless returns of other asset classes caused domestic equity allocation to change markedly).

In fact, in Yale's case the overall portfolio return for the fiscal year amounted to 8.8 percent, implying reasonable stability in portfolio allocations and suggesting modest rebalancing requirements.

For Yale's fiscal 2003, the placid surface of the equity market concealed some powerful undercurrents. Early in the fiscal year, markets collapsed. In July, the Wilshire 5000 posted a peak-to-trough decline of more than 18 percent. The market subsequently rebounded, nearly regaining the July peak in late August with a greater than 19 percent return..

From the August high, the market once again fell, declining by more than 19 percent to what proved the fiscal-year low on October 9^th. The hidden currents continued to roil the markets with a 21 percent increase by November followed by a 14 percent decrease through March. A powerful surge lifted the market by nearly 27 percent to the fiscal-year high in mid June, from which the market drifted down to close the twelve-month period essentially where it started.

The stock market volatility provided numerous opportunities to execute rebalancing trades. Every substantial drop and every meaningful increase allowed investors to buy dips and sell the peaks. During the university's fiscal 2003, rebalancing activity produced a host of profit-generating transactions.

Restoring Asset Classes to Targeted Allocation Levels

As a matter of course, every trading day Yale estimates the value of each of the components of the endowment. When marketable securities asset classes (domestic equity, foreign developed equity. Emerging market equity, and fixed income) deviate from target allocation levels, the university's investment office takes steps to restore the allocation to target levels.

In fiscal 2003, Yale executed approximately $3.8 billion in rebalancing trades, roughly evenly split between purchases and sales. Net profit from rebalancing amounted to approximately $26 million, representing a 1.6 percent incremental return on the $1.6 billion domestic equity portfolio.

Even though rebalancing represents a nice bonus for investors, the fundamental motivation for rebalancing concerns adherence to long-term policy targets. In the context of a carefully considered policy portfolio, rebalancing maintains the desired risk level.

Generating profit while controlling risk represents an unbeatable combination.

Few institutions and even fewer individuals possess the resources to conduct daily rebalancing of investment portfolios. Yet, regardless of the frequency of rebalancing, fidelity to asset-allocation targets proves important as a means of risk control and return enhancement.

Thoughtful investors employ rebalancing strategies to meet policy asset-allocation targets.

*Excerpted with permission of the publisher, Simon & Schuster, Inc. from "Unconventional Success; A Fundamental Approach to Personal Investment," Copyright © 2005 by David Swensen.