Portfolio Rebalancing: Threshold Limits And Correlation Of Assets Are Determining Factors

Includes: TIP, TLT, VEA, VNQ, VTI, VWO
by: Lowell Herr

Rebalancing a portfolio is only useful if there is a strategic asset allocation (SAA) plan and the portfolio holds more than one investment. For example, rebalancing is moot if a portfolio is limited to one investment such as VTSMX or VTI. As soon as one adds another asset class such as a bond (NYSEARCA:BND) and the SAA plan calls for a 60/40 stock/bond ratio, rebalancing is useful.

In addition to holding multiple investments, rebalancing is rarely needed if the holdings in the portfolio are highly correlated. To reduce portfolio volatility one seeks stocks, funds, or ETFs that have low correlations, increasing the probability of rebalancing. If equity holdings decline in value while a low correlated asset such as a treasury holding (TLT for example) resists the decline, then the treasury holding begins to become a larger percentage of the portfolio than called for by the SAA.

To see if an investment carries a low correlation with respect to another investment, portfolio managers need software to determine not only the level of correlation, but how the correlations change when the asset allocation mix is altered. Using five-years of data, the total bond ETF BND has an 8% (very low) correlation with VTI. Yet the BND correlation with VTI moves up to 21% if the VTI/BND ratio is 60/40. Percentage ratios held in a portfolio alter correlation percentages.

Most portfolio are sufficiently complex as they contain more than two investing instruments. Strategic asset allocation plans and correlation software comes into play as one sets up a rebalancing program. Rather than rebalance at a specific time, my preference is to set target limits for each asset class and rebalance when the target thresholds are breached. If one does not want to take the time to monitor a portfolio daily, and most of us don't, then check the target limits each month when the broker monthly statements are available.

How does one determine what target limits to use? Based on a 22-year study, I set the target limits from 20% to 35% depending on the size of the portfolio. The smaller the portfolio, the higher the threshold limits so as to reduce transaction costs and temper turnover.

In the following screen shot, we have the correlation matrix for the Swensen Six portfolio. Equity ETFs; VTI, VEA, VWO, and VNQ carry high correlations with each other. If these were the only investments, rebalancing would be rare as these four ETFs move together. TLT has a low correlation in this mix of assets and TIP is also rather low. With this mix of ETFs, expect to rebalance the portfolio.

The following Dashboard is an example of a strategic asset allocation plan of a modest-sized portfolio. The target or threshold limits are +/- 25%. The percentages with the white background is the target limits and the colored background are the actual percentages held in the portfolio. The red background indicates the current percentage is above target and the purple tells the manager the asset class percentage is below target.

The following Dashboard is built into the TLH Spreadsheet, a portfolio and benchmark tracking spreadsheet available to interested readers.

The following screen shot comes from the Dashboard worksheet of the TLH Spreadsheet and is designed to help the money manager know how many shares of a specific ETF to add or subtract from each asset class. For example, Large-Cap Value (LCV) is above target by 1.0%. The ETF used to represent LCV is VTV. Selling sixty nine or seventy shares of VTV will bring this asset class back into balance. At a glance, the money manager knows exactly how many shares to buy or sell of the representative ETF in order to bring the asset class into balance.

Rebalancing is more frequent the lower the threshold percentage is set and the lower the assets are correlated. From experience, using a 25% threshold limit lowers the number of times a portfolio needs to be rebalanced. If new money flows into the portfolio and dividends are reinvested in asset classes below target, forced rebalancing is rather rare.

Disclosure: I am long VTI, VTV, VEA, VWO, VEU, BND, TLT, TIP, VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.