Historically, portfolio rebalancing has primarily been seen as an annual housekeeping task coinciding with a client’s portfolio review. But in recent years it has taken on a more evidence-based and strategic role.
This has been driven by research into, and deployment of, advanced rebalancing methodologies that seek to aid and improve portfolio rebalancing outcomes.
Despite its operational application and mechanical nature, portfolio rebalancing is a powerful and important tool. Through rebalancing, advisers can potentially optimise returns, control risk, and help to deliver consistent outcomes for their clients.
For advisers seeking to optimise client outcomes, enhance operational effectiveness, and remain at the forefront of best practice, the transition from date to data is one that should be considered.
In the first of this two-part series, we will unpack portfolio rebalancing and discuss the two main methodologies used within the industry: calendar-based and tolerance-based rebalancing.
The second article of this series will discuss ebi’s most recent white paper: Tolerance-based Rebalancing: Data not Date, which analyses portfolio rebalancing across three different approaches assessed using more than 30 years of data.
But what is portfolio rebalancing?
Portfolio assets naturally drift from their target allocation. Different assets have varying growth rates, particularly between (and within) growth-focused assets such equities and protection-focused assets such as fixed income.
This unavoidable consequence of investing can cause a portfolio to drift above or below its target weights and intended risk profile. Portfolio rebalancing is the important process of restoring a portfolio’s drifted asset weightings back to their target allocations.
If we imagine a simple portfolio had initially allocated 70 per cent to equities and 30 per cent to fixed income. Due to strong equity market performance, the equity allocation grows to 74 per cent while fixed income falls to 26 per cent. A rebalance would involve selling 4 per cent of the equity assets and using the proceeds to buy fixed income, restoring the portfolio to its target allocation.
Aside from being a necessary part of portfolio management, rebalancing offers numerous advantages for investors:
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Risk management — Rebalancing ensures portfolios remain within a client’s intended risk profile by selling overweight assets to buy underweight ones.
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Discipline — It brings structure to portfolio management, and avoids reactionary moves during periods of volatility.
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Strategic efficiency — It enables a consistent buy-low, sell-high dynamic, and helps to educate clients to this concept.
While there are key benefits to rebalancing, it is not without its drawbacks. Rebalancing can incur trading costs, trigger capital gains liabilities in taxable accounts, increase time out of the market and can require continuous monitoring (depending on the methodology). These should all be carefully considered when designing a rebalancing strategy.
Rebalancing methodologies
Calendar-Based Rebalancing (CBR) and Tolerance-Based Rebalancing (TBR) are the two most widely used methods for rebalancing portfolios.
