Mutual Fund Quarter-End Rebalancing Effect

Mutual funds are a basket of stocks tailored to the retail investor in the form of a portfolio, and sold primarily through most major financial institutions.  There are many benefits, including affordable to own, asset diversification and easily accessible.

But in exchange for getting access to a hand picked portfolio of stocks, you need to pay a percentage annually, known as the Management Expense Ratio.

Mutual funds exploded in popularity in the United States in the 1920’s, and have grown to be a massive and very profitable industry.  At the end of 2015, there were over 15,000 mutual funds in the United States alone, with combined assets of $18.1 trillion USD.  In mid-2015, approximately 43% of US households held a mutual fund.

As the industry grew, the influence of mutual funds also took hold in equity markets.  These big funds have created seasonal patterns and trends in the stock market that can help traders exploit them for potential profits.

Today we will discuss a phenomenon known as the Mutual Fund Quarter-End Rebalancing Effect.


What is Mutual Fund Rebalancing?

Before we explain the trade-able pattern, let’s take a moment to explain the concept of rebalancing.

Imagine that you decide that you want to invest in a moderate risk portfolio, aimed to be invested in 60% equities and 40% bonds.  This is your standard asset mix that is often targeted by balanced funds.  The 60% stocks will strive to earn growth, while the 40% bonds will add income.

The fund manager then collects all of the money of retail investors into one pool, and allocates 60% of it to purchase equities on the stock market, and 40% to purchase bonds.

Now let’s imagine that in 3 months time, at the end of the quarter, the stocks have grown in value and now represent 70% of the total assets, with bonds the remainder of the 30%.

What must a mutual fund manager do?

They must restore the original asset mix investors were seeking, and sell some stocks to buy bonds, to bring it back in line with the 60/40 split.

What effect will that have on the market?

Because of all the mutual fund companies selling at the same time, this will lead to a drop in stock market prices as supply overwhelms demand.


Mutual Fund Rebalancing – Time Period

Every quarter, mutual funds send statements to their clients to show their total returns over the past three month period.  This occurs at the end of March, June, September and December of every calendar year.

Now, imagine that a mutual fund manager must sell equities before the end of the current calendar quarter.  When would you expect these transactions to flood the market?

You guessed it, at the end of each quarter.  The time period typically tends to be the last 3 days of the last month of a quarter.

This upcoming week is a perfect example, as mutual fund managers will be out in the market in full force selling their equities to collect cash and purchase bonds in order to restore the desired asset mix.

In general, the last 3 days of March, June, September and December are most prone to selling, especially if the current quarter has experienced a stock market rally.


Mutual Fund Rebalancing – the Effect of Redemption Requests

When an investor sells their mutual fund to cash out, this is referred to as a “redemption request”.  Often time, investors review their portfolios on a quarterly basis when they receive their statements from their mutual fund company.

If an investor wishes to get out, they will sell their units.  When a large group of investors all demand their money at the same time, a mutual fund must sell some of their portfolio positions to pay out the investors.

This redemption request phenomenon creates a wave of further supply, and intensifies the selling on the open market, which can drag stock markets lower.

When there are a lot of redemption requests, along with the need to rebalance portfolios, this can spark a late month sell-off.


Mutual Fund Rebalancing – The Trading Opportunity

Traders that know how to spot these mutual fund patterns can capitalize on a quarterly basis.

The quarter-end mutual fund rebalancing trade is simple:

  1. Sell equities the last 3 to 5 days of every calendar quarter month
  2. Buy bonds in the same time period
  3. On the first day of the following quarter, reverse this position for 3 days (buy equities and sell bonds)

Here is an example using this September:

  1. Purchase put options on the SPY ETF on Tuesday September 27th
  2. Sell these put options on Friday September 30th in the afternoon
  3. On Monday October 3rd, buy the SPY ETF call options and hold them until Thursday October 6th

A word of caution is a good idea at this point.

The trained trader has a strategy they follow and trust.  If your strategy gives you a signal that diverges from this end of quarter trade, it is best to go with your proven system over taking a gamble on this calendar effect. That is, if your strategy says to buy in the last 3 days, then listen to it.  Or stay out altogether.

We find this trade to be the most successful when your strategy confirms with the quarter-end rebalancing opportunity.


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The information contained in this post is solely for educational purposes, and does not constitute investment advice.  The risk of trading in securities markets can be substantial.  You should carefully consider  if engaging in such activity is suitable to your own financial situation.  TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.