- Ideally, to eliminate style drift investors should rebalance daily. However, because the real world involves costs, investors should reduce, not eliminate, style drift to an acceptable level.
- Investors should rebalance wherever there is sufficient cash to make the effort worthwhile, thus eliminating any tax issues and either eliminating or minimizing trading costs.
- An investor’s investment policy statement (IPS) should include targeted asset allocations as well as minimums and maximums and a rebalancing table.
Rebalancing is the process by which a portfolio's "style drift" caused by market movements is eliminated or minimized. Style drift causes the risk and expected return of the portfolio to change. Thus, if you want to eliminate style drift, you should rebalance daily. However, in the real world there are often costs (trading expenses and in taxable accounts taxes) including the time and effort to rebalance. Thus, you want to reduce (not eliminate) style drift to an acceptable level. That raises the question of how to determine when you should rebalance.
First, you should rebalance whenever you have sufficient cash to make the effort worthwhile. That eliminates any tax issues and it either eliminates or minimizes trading costs (depending on the investment vehicle and the custodian). This is the way many endowments (such as the Yale Endowment) rebalance, using the cash flows they donors as well as the interest and dividends provided by their portfolios.
Second, you can choose not to automatically reinvest dividends, interest, and distributions. Instead, take them in cash and rebalance using the proceeds. In that way you limit transactions to only purchases, avoiding sales and the tax consequences that can accompany them in taxable accounts. This is generally a good choice, though it may not be appropriate for small accounts where the custodian is charging a minimum fixed transaction fee. If the fee is large relative to the size of the distributions, you would be better served reinvesting the proceeds as there's no transaction fee.
Third, before rebalancing that requires the realization of taxable gains, you should determine if in the near future you will have new investable funds (e.g., bonus, maturing bond, the sale of security) that will become available. If this is so, you should consider delaying rebalancing, as long as the delay is a relatively short one. The exception to the guidance on minimizing the realization of gains when performing rebalancing is when there are long-term gains that can be realized from the sale of taxable fixed income investments. Here the "conventional wisdom" gets spun on its head. If there is a long-term gain that could be realized (whether for rebalancing purposes or not) investors in all but the lowest bracket should take it. The reason is that doing so converts future interest income that would have been taxed at the ordinary income tax rate (e.g., 35 percent) into a long-term capital gain that is taxed at a rate of only 20 percent. Of course, the loss of the present value of having to pay taxes early, as well as the costs of the transaction should be considered.
Fourth, I would generally recommend not rebalancing if it meant having to realize significant short-term capital gains (unless offsetting losses were available). Instead, you should consider waiting until the gains become long term. If taxes are an issue you might also consider rebalancing to minimum and maximum levels, instead of to the targeted level.
Fifth, rebalancing should be considered in tax-deferred accounts first, if doing so avoids realizing capital gains. However, if capital losses are available (and that should be determined at individual lot levels), then the rebalancing should be done in the taxable accounts. It is important to note that the belief "if I have all asset classes represented in tax-deferred accounts, that will allow me to tax-efficiently rebalance in the future," isn't correct. The reason is that the tax inefficiencies deriving from the wrong location are greater than any benefit when rebalancing is needed.
Sixth, since rebalancing is about managing style drift, it shouldn't be based on time. Instead, it should be based on how much style drift you are willing to accept as the price for keeping costs (especially taxes) low.
The Rebalancing Table
Included in your investment policy statement (NYSEARCA:IPS) should be an asset allocation and rebalancing table. The table should include not only the target levels for each asset class, but also the minimum and maximum levels to which the allocations will be allowed to drift. Some drift should be allowed to occur because rebalancing generally involves costs, including transactions fees and taxes in taxable accounts.
I suggest you use a 5/25 percent rule in an asset class's allocation before rebalancing is considered. That is, rebalancing should be considered if the change in an asset class's allocation is greater than either an absolute 5 percent or 25 percent of the original percentage allocation. Note that the actual percentages used are not as important as having a specific plan and having the discipline to adhere to the plan. In other words, a 4/20 rule might be as appropriate as a 5/25 rule.
Application of 5/25 Rule: Assume an asset class was given an allocation of 10 percent. Applying the 5 percent rule, one would not rebalance unless that asset class's allocation had either risen to 15 percent (10 percent + 5 percent) or fallen to 5 percent (10 percent - 5 percent). Using the 25 percent rule one would, however, reallocate if it had risen or fallen by just 2.5 percent (10 percent x 25 percent) to either 12.5 percent (10 percent +2.5 percent) or 7.5 percent (10 percent - 2.5 percent). In this case the 25 percent figure was the governing factor. If one had a 50 percent asset class allocation, the 5/25 percent rule would cause the 5 percent figure to be the governing factor since 5 percent is less than 25 percent of 50 percent, which is 12.5 percent. In other words, one rebalances if either the 5 percent or the 25 percent test indicates the need to do so.
The need for rebalancing should be checked at three levels.
- At the broad level of equities and fixed income.
- At the level of domestic and international asset classes.
- At the more narrowly defined individual asset class level (such as emerging markets, real estate, small-cap, value and so on).
Applying this rule you can produce a rebalancing table that looks like the one below:
Sample Rebalancing Table
Minimum Allocation (%)
Target Allocation (%)
Maximum Allocation (%)
U.S. large value
U.S. small value
International large value
International small value
Total Fixed Income
It's important to understand that rebalancing is more important when asset classes that are out of balance have low correlation (the strength of the linear relationships between asset classes). For example, the annual correlation between the S&P 500 and Treasury bonds has been about 0 (there's no correlation). That makes rebalancing when these two asset classes are out of balance very important. However, the annual correlation between U.S. small value stocks and U.S. small stocks has been 0.97. And the annual correlation between U.S. small value stocks and U.S. large value stocks is about 0.9. In either of these cases, if these asset classes exceed their tolerance ranges at the same time, and your over the max in one and under in another, and there are significant costs that would be incurred, you can decide to wait, accepting the style drift because the correlations are so high. On the other hand, the correlation between U.S. stocks and emerging markets stocks is much lower (about 0.6), making it more important to rebalance. In other words, rebalancing is as much an art, balancing the benefits of controlling risk with the costs of doing so. Rebalancing in the most cost and tax efficient manner is one of the ways a good financial advisor can add value.
Myths about Rebalancing
Unfortunately, what passes for conventional investment wisdom often isn't true. A good example is that there are two myths about the rebalancing. These myths need to be exposed.
Reversion to the Mean
The first myth is that rebalancing is a "reversion to the mean" strategy. An example will demonstrate that this is false. Consider a portfolio with an asset allocation of 50 percent stocks/50 percent bonds. Assume that stocks have returned 10 percent and are expected to return 10 percent while bonds have returned 6 percent and are expected to return 6 percent. The first year stocks return 9 percent and bonds return 7 percent. A strategy that is based on reversion to the mean of returns would sell bonds (since they produced above average returns) to buy stocks (since they produced below average returns). However, since the portfolio now would have an asset allocation of greater than 50 percent for stocks, rebalancing would require that stocks be sold to buy more bonds - or buy sufficient bonds to increase the bond allocation to 50 percent.
A Way to Increase Returns
The second myth about rebalancing is that it increases returns. An example will demonstrate why that will not be the case most of the time. The majority of the time rebalancing will require investors to sell some of the higher expected returning asset class to purchase more of the lower expected returning asset class. For example, most of the time we would expect to have to sell stocks to buy fixed income assets. Similarly, we should expect that the majority of the time we will have to sell value stocks to buy growth stocks, small stocks to buy large stocks and/or emerging market stocks to buy developed market stocks. In each case, the majority of the time we will be selling the higher expected returning asset class to buy the lower expected returning asset class. While achieving the objective of restoring the portfolio's risk profile, rebalancing, in each of these cases, lowers the expected return of the portfolio. (This is why many recommend infrequent rebalancing - because they are focusing on maximization of returns, not controlling risk.) Of course, this won't always be true. When bonds outperform stocks, rebalancing will increase the expected return of the portfolio since you are reducing the allocation of the lower expected returning asset class in order to increase the allocation of the higher expected returning asset class.
The bottom line is that an important part of the winning investment strategy is the establishment of an IPS that includes your targeted asset allocations as well as minimums and maximums. The only way to adhere to that IPS is to rebalance. Be sure to rebalance whenever you have available cash. Otherwise, check for the need to rebalance monthly, or at least quarterly. If you don't, you could see the portfolio drift to an unacceptable level of risk.