The majority of a portfolio’s risks and returns boil down to asset allocation. Over time, a portfolio’s asset allocations drift as some assets outperform others. Rebalancing the portfolio resolves these issues by selling overweight assets and using the proceeds to buy underweight assets. This maintains the portfolio’s risk and return characteristics.
In this article, we will look at three rebalancing strategies, the pros and cons of each, and other important considerations.
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The Three Rebalancing Strategies
There are many different ways to rebalance a portfolio, including periodic rebalancing, tolerance band rebalancing, and a hybrid periodic-and-threshold approach. Each of these methods has pros and cons that impact the risk-adjusted return and transaction costs that are incurred during the process.
Periodic, or time-only, rebalancing is the easiest way to rebalance a portfolio. The strategy involves rebalancing the portfolio every day, month, quarter or year regardless of how much its asset allocation has drifted from the target. The frequency of the rebalancing depends on the investor’s risk tolerance and the cost involved with rebalancing the portfolio.
Tolerance Band Rebalancing
Tolerance band, or threshold, rebalancing ignores time and focuses on the asset allocation’s drift from the target asset allocation. When a portfolio drifts beyond a certain threshold, such as 1%, 5% or 10%, the portfolio is rebalanced. The frequency of rebalancing depends on the nature of the assets (e.g., their volatility) and the chosen threshold.
Taking a Combined Approach
Combined, or time-and-threshold, rebalancing incorporates concepts from both periodic and tolerance strategies. On a predetermined date, the portfolio manager or investor checks to see if the asset allocation drifted beyond a certain threshold. If it has, the portfolio is rebalanced; if not, the portfolio is not rebalanced at that time.
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Implementing a Strategy
The two biggest considerations when implementing a rebalancing strategy are the portfolio’s risk and return characteristics and the rebalancing costs (e.g. transaction costs and time).
- Portfolio Risk-Return – Rebalancing a portfolio maintains the ideal risk and return characteristics, but these differences aren’t necessarily material to investors. For example, Vanguard found that there was little meaningful difference between monthly and annual rebalancing in terms of a portfolio’s overall risk and return profile.
- Rebalancing Costs – Rebalancing costs, including time, labor, and trading costs, can have a material impact on returns. These costs are usually included in advisory fees for managed portfolios, which makes them difficult for investors to assess. In addition to the costs, rebalancing can lead to portfolio turnover that may impact tax liability.
The most cost-effective way to rebalance a portfolio is using dividends, interest payments, realized capital gains or new contributions since there’s no need to incur extra transaction costs. By transferring these cash flows into a money market account, investors can redirect capital to underweight asset classes as part of their rebalancing strategy.
Another way to reduce the costs of portfolio rebalancing is to rebalance to an intermediate asset allocation rather than the target asset allocation. For example, an investor may want to minimize the size of a transaction by investing in one asset rather than multiple if the cost of commissions or taxes is significant or the allocation amount is small.
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The Bottom Line
Asset allocation plays an important role in the risk and return characteristics of a portfolio. As a portfolio’s asset allocation drifts over time, it’s important to rebalance the portfolio to ensure that it maintains the optimal risk and reward characteristics.
The best rebalancing strategy depends on a portfolio manager’s or investor’s goals. While risk-adjusted returns aren’t meaningfully different between strategies, the number of rebalancing events and the costs associated with them can be significantly different.
Investors should consider all of these factors when deciding on the best rebalancing strategy for their portfolios.
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