Author: Tim Courtney
A considerable amount of questioning, organizing and thinking goes into the process of determining how an individual should invest their savings. Factors like age, expected cash flows, family goals, risk tolerance and taxes are all taken into account when constructing an investment strategy. The initial purchase and weighting of securities and assets is the culmination of much planning and thought.
Once these purchases are made though, market prices begin to change. Certain assets outperform, and what was initially a 10 percent weight to an investment may become a 15 percent weight. Other investments underperform and may try an investor’s patience. After some time, the prices and weights in the portfolio may look much different than they did at inception.
At this point, we face a decision: What, if anything, should be done with the investments and their weights? Exencial views these price and weight changes as an opportunity to improve risk management and/or expected return through rebalancing1, the process of realigning the weightings of a portfolio. Many investors are familiar with this concept but are often unaware of its benefits.
In practice, rebalancing is similar to what prominent investor Benjamin Graham described as interacting with “Mr. Market.2” At certain times, Mr. Market is euphoric and will offer to buy certain assets at high prices or valuations. Investors should consider selling at least a piece of high-priced assets at these times. Other times, Mr. Market is depressed and will offer to sell certain assets at lower prices or valuations. This is when an investor should consider buying some of these assets.
A primary benefit of rebalancing is improved risk management. To safeguard your portfolio, it’s critical to ensure that a few assets don’t grow so large as to dominate a strategy or that a few components’ weights wither to a point that they no longer serve their intended purpose. Rebalancing these assets validates and maintains the original investment strategy.
Another advantage of rebalancing is the potential for higher expected returns. Inevitably, some assets will perform better than others over a period of time, and the weights to the investments will begin to drift from their initial targets. When the investments’ weights drift too far from their targets, it may make sense to sell overweighted assets and buy underweighted assets to try to return weightings closer to their initial target.
The above sample portfolio is weighted to the following indexes: 6 percent DJ U.S. Select REIT, 15 percent S&P 500, 15 percent Russell 1000 Value, 15 percent Russell 1000 Growth, 20 percent Russell 2000 Value and 29 percent MSCI Europe USD GD. Rebalances are done every 12 months back to target.
We can see that rebalancing significantly improved this portfolio’s returns over the long term. Below are several highlights:
• Rebalancing improved this equity portfolio’s return by 0.42 percent per year over this roughly 34-year period.
• Looking at all 60-month rolling periods within this timeframe, a rebalanced portfolio outperformed a non-rebalanced portfolio in 291 of 345 (84 percent) periods. The average outperformance of the rebalanced portfolio in the 345 periods was 0.35 percent per year.
• Looking at all 120-month rolling periods, the rebalanced portfolio outperformed in all 285 (100 percent) periods by an average of 0.32 percent per year.
Certainly not every rebalance trade provides a “bonus,” especially in the short term. However, historically, rebalancing has provided investors with higher returns over longer periods of time. A recent study conducted by Vanguard3 estimates returns can be improved 0.35 percent per year through rebalancing. As mentioned, Exencial has also analyzed historical rebalancing and has discovered a similar benefit.
There are trading costs and potential taxes to be considered though, which is why we attempt to rebalance our clients’ assets in an efficient and cost-conscious manner. To accomplish this, we follow the below guidelines when rebalancing:
• Band rebalancing: We rebalance when investment weights move outside an acceptable band, such as 8 to 12 percent. This allows assets that are outperforming or underperforming to continue to do so without constantly having to pare or buy back to a target weight respectively.
• Tax-efficient rebalancing: Whenever possible, we rebalance an overall portfolio using assets within a tax-deferred account, such as an IRA, Roth IRA or 401(k) to avoid realizing taxable gains. If sells must be made in an account that will generate taxable gains, we sell lot specific shares or positions with smaller gains to minimize taxes.
• Review frequently, trade less frequently: We review accounts throughout the year and rebalance only when assets have moved outside their bands, rather than rebalancing back to target weights on calendar intervals. This generally reduces the number of trades, trading costs and realized gains.
• Use cash to rebalance when available: When possible, we prefer to use available cash from deposits, interest, dividends and fund distributions to rebalance into underweighted areas to avoid having to sell appreciated positions.
Rebalancing helps manage risks and can put investors in a position to capture slightly higher expected returns. Exencial seeks to capitalize on these benefits while also taking judicious measures to avoid unnecessary trading costs and tax burdens. For additional information or if you have questions, please contact your advisor.
1. Investopedia – Rebalancing
2. Investopedia – Mr. Market
3. Vanguard – Putting a value on your value: Quantifying Vanguard Advisor’s Alpha®
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