Drift Risk Rebalance Frequency Annualized Drift Risk Quarterly 0.22% Semiannually 0.27 Annually 0.40 Biannually 0.70 portfolio of index funds that is exactly at benchmark at the end of one month. If stocks outperform bonds by 4 percent over the next month-approximately a one standard deviation event-at the end of the month its new allocation will be 60.9 percent/39.1 percent.4 This 0.9 percent mismatch equals about 0.19 percent of unintentional tracking error to the strategic benchmark. Naturally, the risk in drift increases in the time between rebalances. Table 22.1 shows the average unintentional drift risk from different rebalance frequencies based on historical simulations. On average, plans that rebalance once a quarter experience 0.22% drift risk, while those rebalancing only once a year incur 0.40% in unintentional risk. This assumes that the underlying asset returns are the same as the benchmark. Actively managed underlying assets will cause even larger deviations and drift risk. Even worse, the drift risk is the worst kind of risk because it is highly correlated with the strategic benchmark. In the previous example, that 0.19 percent of tracking error translates into a 0.17 percent increase in total portfolio volatility. Such an increase in volatility is equivalent to a 200 basis point increase in uncorre-lated active risk on the total portfolio. In other words, the drift from a rather typical one-month return on stocks and bonds has the same impact on total risk of the plan as the entire active risk budget for an average plan! Table 22.2 demonstrates the significance of the correlation between drift and benchmark risk. We simulated returns for an aggressive U.S. plan with a large pool of active managers and fixed benchmark weights for U.S. large-cap, mid-cap, and small-cap stocks, international stocks, U.S. bonds, and international bonds.5 We found that rebalancing only once per quarter meant that 14 percent of the time the absolute return from unintentional drift exceeded the absolute return from intentional active risk. Rebalancing only once per year increased the frequency to an astounding 39 percent of the time. When hearing this, our clients sometimes ask whether there is any additional return to intentionally following a drift strategy, in spite of the clear increase in risk. Although not rebalancing might be thought of as an asset class momentum 4For this example, we assume annual stock and bond volatilities are 20 percent and 5 percent, and that stock-bond correlation is 0.1. 5Example was based on an existing client. Their benchmark is 32 percent U.S. large-cap, 12 percent U.S. mid-cap, 14 percent U.S. small-cap, 17 percent international equity, 15 percent U.S. bonds, and 10 percent international bonds. The example assumes 26 individual managers across these six asset classes with active risk averaging approximately 9 percent for each equity manager and 2.5 percent for each bond manager.