Rebalancing 101

Rebalancing is an essential piece of the portfolio management process. Inherent differences among asset classes (e.g., stocks, bonds, and real estate) mean that the size and/or direction of their returns will likely differ over time. There may be periods of time where one asset is up, and one is down, or some assets are simply generating significant returns relative to the rest of the portfolio. The bottom line is that the exact composition of one’s portfolio is always changing.

The ever-changing nature of a portfolio is commonly referred to as “asset drift.” Left unchecked, strong performing asset classes may grow disproportionate to one another. The long-term consequence of asset drift is an altered risk level for the portfolio, which in turn may impair the ability to reach long-term financial goals. Portfolio rebalancing involves reducing portfolio exposure to assets that have recently outperformed on a relative basis and buying those which have underperformed. By implementing a structured rebalancing strategy, investors are able to limit asset drift, thus ensuring a consistent risk-return profile over their investment horizon.

Rebalancing also ensures that securities will be bought at relative lows and sold at relative highs. The structured process of rebalancing acts as a safeguard against the tendency of investors to chase top-performing assets. While rebalancing into stocks may seem counterintuitive at times of poor market performance and high uncertainty, investors who do not rebalance their portfolios will not only fail to maintain their target allocation, but will also limit their participation in subsequent equity returns as markets recover.

So, knowing all of this, we are left posing one question: How does one decide when to rebalance?

There are two general strategies that investment managers often use to rebalance portfolios: calendar rebalancing and contingent rebalancing.

• Calendar rebalancing involves rebalancing all assets back to target on a predetermined schedule (i.e., quarterly, semiannually, etc.). This means that rebalancing does not take place within the interval, but instead all assets are rebalanced to target at the end of each time period.
• Contingent rebalancing is monitored in real-time, and assets are only rebalanced back to target if they breach specified rebalancing bands. This method has the advantage of being much more selective, meaning that only assets outside of their rebalancing bands are traded back to target (selling high-performing assets and buying low-performing assets). The size of these rebalancing bands should be a key consideration when setting up a rebalancing strategy as they will dictate how frequently rebalancing may occur. Rebalancing bands that are too wide will likely miss out on rebalancing opportunities and the portfolio will be exposed to more risk, while bands that are too narrow may trigger too many trades, resulting in excessive trading and transaction costs.

Without the ability to accurately predict the future direction of market returns, it is impossible to know exactly when making a rebalancing trade will boost the returns of the portfolio. What we do know is that, historically, asset classes have exhibited long-term mean-reversion. More plainly stated, this means that when an asset class falls in price, it results in a more attractive valuation, and is therefore more likely to experience higher subsequent returns. As a result, rebalancing can enhance returns over the long term by opportunistically capitalizing on the mean-reverting tendencies of asset classes.

While rebalancing can add value over the long term, it may have different effects based on market conditions. Generally speaking, in periods of high volatility (think up and then back down), rebalancing will likely enhance returns because one will probably have rebalanced prior to the reversion, thus participating more in the market recovery. Conversely, in trending markets characterized by low volatility (think of a straight line with an upward trajectory), rebalancing could actually detract value from the portfolio (in terms of performance, not risk) by reducing exposure to higher-returning assets. In other words, if the markets always grew, there wouldn’t be any risk to allowing your portfolio to become almost entirely allocated to the riskiest assets.

Regardless of the specific rebalancing strategy one decides to employ, a structured strategy with clearly defined rules prevents investor emotions from clouding the decision making process. Remember that the ultimate goal of rebalancing a portfolio should be to manage risk and maintain a targeted asset allocation, not to pursue additional return.