A New Way To Rebalance

Includes: AGG, EFA, SPY, VTI
by: The Chestnut

Too often, when constructing their portfolios, investors make a critical mistake. Focusing solely on asset selection and portfolio allocation, they spend little time thinking about a key issue: how to rebalance the portfolio over time. Rebalancing is critical. It reduces a portfolio's volatility and increases its return per unit of risk taken. It also mutes the effect of behavioral biases - an investor is much more likely to stay with a portfolio that, through regular rebalancing, is brought back to its original allocation. Yet, many investors mistakenly assume that only one method of rebalancing exists: a calendar-based rebalancing approach. Hopefully, this article will dispel that notion. It will also teach you a few tricks along the way.

Three New Ways to Rebalance

A calendar-based rebalancing approach - which involves rebalancing quarterly or yearly, for example - is merely one method of rebalancing. In fact, different ways to rebalance exist. Selecting between these options is ultimately a personal decision. Each of the following methods requires you to decide how far you will let your investments stray from their allocations before rebalancing. This will depend on individual factors, such as your own personal risk tolerance. It will also turn on whether you will pay commissions on the transactions or whether you will incur capital gains taxes on the sale of the appreciated assets. In general, taxes and commissions owed, higher risk tolerances, and less time to monitor your investments all weigh in favor of more infrequent rebalancing.

1.) Percentage or Threshold Rebalancing

This method demands rebalancing the portfolio when it crosses set percentage thresholds. Notice how this method differs from a regular calendar-based approach. An investor following a yearly, calendar-based approach will only rebalance at a set date each year. As a result, the portfolio may fluctuate widely in the interim, without being subject to rebalancing. The same is not necessarily true with a threshold rebalancing method. For example, suppose your $100,000 portfolio consists of 50% VTI and 50% AGG. You purchased VTI at $77.56 and AGG at $110.25. You decide that you will only rebalance when the assets break their set allocations by a 5% threshold. If VTI fluctuates between trading bands, and then suddenly jumps to $85.50 after two years, while AGG remains relatively stable at $110.25, VTI will officially comprise more than 55% of the portfolio. And so, your 5% threshold is triggered and you will buy more of AGG to bring the portfolio back into balance (i.e. returning it to the 50%/50% allocation). Notice that, in contrast to the calendar-based method, a threshold rebalancing approach rebalances the portfolio only when the assets stray from their original allocations by a fixed percentage. In the above example, this occurred after two years; but it might occur after three years or three months or three days, depending on the volatility of the stock and the threshold percentage itself. The key decision that an investor must make before adopting this method, then, is determining the threshold percentage. According to one study, portfolios that set 1%, 5%, and 10% thresholds all boasted similar returns. A risk-averse investor may lean towards setting a low threshold, but keep in mind that setting low thresholds increases monitoring costs. An asset may break the percentage threshold daily or weekly, if set too low. In addition, if an investor is paying taxes on the gains and/or paying commissions on the transactions, the costs of implementing a threshold approach with a low threshold will likely outweigh the benefits.

2.) Hybrid Rebalancing

A hybrid method of rebalancing requires rebalancing on a set date, but only if the portfolio exceeds a percentage threshold on that date. You will not touch the investments in the interim, regardless of how much they fluctuate. Return to the AGG and VTI example. Suppose that this time, rather than adopting a threshold rebalancing method, you adopt a hybrid method. You decide that you will (1) only rebalance yearly (on June 1) and (2) only if, on June 1, your allocations exceeded a 5% threshold. After the first year, in the above example, you would not have rebalanced. Both AGG and VTI traded within tight trading bands, with neither comprising more than 55% of the portfolio. After the second year, however, you would rebalance - but only if VTI still comprised 55% or more of the portfolio on June 1. Notice that this method is a combination of the calendar-based approach and the percentage-based approach. It combines some of the benefits of both approaches. It involves less monitoring than a purely threshold approach, while - due to the threshold limitation - allows you to incur the costs of rebalancing only when necessary (i.e. when the threshold percentage is crossed). Unlike a calendar or threshold approach, however, adopting a hybrid rebalancing method requires you to make two decisions as opposed to one: (1) how often to rebalance (such as every 6 months or every year) and (2) the percentage that triggers the rebalancing on that date (such as 5% or 10%). Again, the input for each will depend on individual factors, such as your own personal risk-tolerance. Investors that are unable to regularly monitor their investments, but who have a higher risk tolerance, will likely prefer the hybrid approach to a threshold one.

3.) 'Rebalancing' via Options

This is a third, less-conventional method of rebalancing. Only those who are invested in ETFs or can otherwise write options against their investments can deploy this strategy. At its core, this method is a more sophisticated version of the hybrid approach. It works as follows. Suppose you want to rebalance every six months, but only if your investments cross a 10% threshold. You own SPY and EFA. At the beginning of each six-month period, for each ETF, you will: (1) sell calls on that rebalancing date at a strike price equal to 10% above the current market price and (2) sell puts equal to 10% below the current market price. This means, effectively, that if the stock is above the 10% threshold when or before the option expires, it may be called away from you (and you will keep the proceeds from the covered call you sold). If it is below the 10% threshold when or before the option expires, it may be put to you (and you will have to buy the stock at the strike price you sold the put at). As a result of risk of the stock being put to you, you should keep cash in your account available to buy the stock if it is put to you.

This strategy comes with a few caveats:

First, unlike with a standard rebalancing approach, you can 'lose' money in a few ways with this strategy. If either SPY or EFA appreciates significantly (i.e. breaking through your threshold percentage), your stock will be called away from you - but at the strike price you sold, not at the prevailing market price. You effectively sell the stock at that strike price (and pocket the proceeds). This means that you miss out or 'lose' any further appreciation. A similar risk exists with the puts. If either SPY or EFA drops in value significantly, you will be forced to buy the stock at the strike price you sold it at, not at the prevailing market price. In essence, you will be paying more for the stock than it's currently worth.

Second, the sold calls and puts generate the most cash (1) the lower your threshold percentage (and so, the closer the strike price is to the current market price) and (2) the further out your rebalancing date is (i.e. 1 year will generate more than 6 months, which will generate more than 3 months, etc.). This has to do with the premium inherent in the calls and the way option prices are calculated. The bottom line is as follows: the higher you set your threshold percentage and/or the more frequently you rebalance, the less effective this strategy becomes (and the more the risks begin to outweigh the benefits). For investors who want to rebalance frequently and/or prefer threshold percentages of 10% or more, this strategy likely isn't for you.

Third, this is an incredibly inefficient rebalancing approach from a tax perspective. You trigger gain on the income generated by the sold puts and calls. You will also incur commissions when you sell the puts and calls. From a tax perspective, this strategy is best done in a tax-advantaged account. And from a commissions perspective, this strategy is best if used infrequently (i.e. 6-month or 1-year rebalancing dates).

But with that said, this strategy accomplishes something that many other rebalancing strategies do not: it lets you generate a steady stream of income. In doing so, it will effectively increase your return per unit of risk taken.

Please be sure to familiarize yourself with the means of writing calls and the risks and rewards inherent in doing so, before utilizing this strategy.

Three Sophisticated Tricks to Use When Rebalancing

Too many investors fail overlook simple strategies with rebalancing that can decrease taxes and increase returns. Here are three tricks you can use to do just that:

1.) Donate Appreciated Assets to Charity, if Using a Taxable Account

When you donate appreciated stock in-kind to a qualified organization, you usually get to claim a deduction for the full fair-market value of the stock. Only those who are rebalancing their taxable accounts should consider this strategy. This is because the primary benefit of this strategy is to avoid the capital gains taxes triggered by the sale. If you were to sell the stock, your deduction would be less in a taxable account; it would only be for the fair-market value less taxes paid. Consult a tax advisor or financial planner to determine if you would benefit from this deduction. Keep in mind that limitations to deductibility apply, that limitations apply as to which stocks are eligible for deductions (depending on how long you have held the stock), and that tax consequences may arise depending on what the charity does with the stock. In general, this strategy seems best fit for (1) high-bracket taxpayers, (2) who rebalance a taxable, brokerage account, and who (3) have enough free cash to purchase the depreciated asset in the account, without having to rely on the proceeds of the appreciated asset to rebalance the portfolio. If there is enough free cash to both pay the taxes and to buy the depreciated assets to bring the portfolio into balance, the taxpayer yields a double-benefit: a deduction and a newly-balanced portfolio, without selling any assets.

2.) Rebalance Based on Context

Investors often think that picking a rebalancing method is a one-time decision. But in reality, the rebalancing method that works best in a secular bear market is likely not the one that will work best in a secular bull market. In essence, a secular bear market weighs in favor of tighter, narrower thresholds and - to a lesser extent - more frequent rebalancing. A secular bull market weighs in favor of wider, greater thresholds and - also to a lesser extent - less frequent rebalancing. The idea is to minimize the downside of individual assets during the secular bear market, while to let the assets "run" as much as possible before rebalancing in a secular bull market. However, this leaves the portfolio prone to your behavioral biases. Specifically, how do you know when the market is in a secular bull or secular bear market? One potential way to avoid over-trading and to minimize the effect of your own behavioral biases is to choose and stick to an objective, third-party indicator. Whether this is a specific metric or something else is an individual decision. The point is to rely on this metric and to make the pivoting between two pre-determined rebalancing methods - one for secular bull markets and one for secular bear markets - as mechanical as possible.

3.) Only Buy More or Harvest Tax Losses

I mentioned this in my prior article, but make sure to rebalance using a tax-efficient strategy if you are using a taxable account. This means that, when using one of the traditional rebalancing methods, to only buy the declined assets to bring them to balance. This avoids capital gains taxes inherent in the sale of appreciated assets and only results in one level of commissions. If you are both buying and selling, however, try to harvest your tax losses. I flag one tax-efficient way to do this in my prior article, along with a more sophisticated method for those so inclined.


At this point, I hope you realize that the rebalancing decision is far from simple. Many different tricks and methods exist. The goal is to pick one that not only matches your risk profile, but also minimizes taxes and boosts your return per unit of risk taken. And as always, please consult a tax advisor, financial planner, and/or conduct your own research before making any investment decisions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author.