Investor's Alpha: Systematic Portfolio Rebalancing

by: Adam Hoffman, CFA

Summary

Systematic portfolio rebalancing forces the ultimate investor axiom to hold true: Buy low, sell high.

Portfolio rebalancing is a risk mitigation strategy, not a return maximization strategy.

A rebalanced portfolio will outperform in an oscillating market.

With the possibility of low returns over the next five to ten years, the challenge is how to increase returns without taking on undue risk. Peak Capital posits that the key to enhancing returns in the "new normal" is to focus on factors that the investor controls:

  • Savings Rate & Spending Rate
  • Systematic Portfolio Rebalancing
  • Proper Asset Allocation
  • Tax Management
  • Proper Asset Location
  • Investment Expense

For those that read our 2017 Economic Projections, you will be familiar with these areas of return. These six inputs to the investment process can help improve portfolio outcomes where the market is expected to return ~3% for a 60% global equity and 40% fixed income portfolio. In this part of our Investor's Alpha series, the focus will be on the value that systematic portfolio rebalancing can add on your returns. Some of this value will be readily apparent on a portfolio summary - increased return - and part of the value will not be tangible on a brokerage statement - reduced risk. The goal of the Investor's Alpha series and this part is to illustrate the value of investor controlled inputs to increasing portfolio returns and meeting investor objectives.

Systematic portfolio rebalancing forces the ultimate investor axiom to hold true: buy low, sell high. Having a set of rules to guide the construction and maintenance of the portfolio can enhance returns. Vanguard Advisor's Alpha (1) research paper concludes that annual portfolio rebalancing may add up to 0.35% to portfolio returns for a 60% stock/40% bond portfolio. It is also important to note that rebalancing is not a return maximization strategy; rather, it is a risk realignment strategy. Without rebalancing, over time the more volatile assets will increase in relative size to less volatile holdings, i.e. without rebalancing stock allocation will increase.

For this paper, we will explore how portfolio rebalancing impacts a portfolio during volatile market periods as well as during periods of steady, positive growth. The 60% stock/40% bond portfolio that we will be referencing is composed of Vanguard's S&P 500 Index fund (MUTF:VFINX) and Vanguard's Total Bond Market Index Fund (MUTF:VBMFX) (2) The timeframe that we are examining is from 2001 to the end of 2016, which has readily available performance data on Vanguard.com. This time period captures two bull markets as well as two recessionary periods: the Dot-Com bubble of 2001 and the Housing Crash of 2008. For the more technically astute, it will be glaringly apparent that we have omitted advanced risk metrics in the discussion as we believe that the benefits of rebalancing can be made without these metrics.

The two main benefits of having a set of rebalancing rules for a portfolio is to maintain the desired risk exposure of the portfolio and to provide behavioral discipline for an investor. If we invested $100,000 in 2009 and did not rebalance, the value of the portfolio at the end of 2016 would be ~$228,500 with ~$175,000 in equities, or 77% of the portfolio. The lack of rebalancing has transformed a moderate portfolio to one that can generally be categorized as aggressive; the risk profile has greatly changed and is too aggressive for a moderate investor especially if there have been no changes to their objectives and constraints (time horizon, liquidity, taxes, etc.). In other terms, would a moderate investor want to go into 2008 with a portfolio that is nearly 80% in equities?

The chart above illustrates the difference in equity exposure for a 60/40 portfolio that is rebalanced annually at the end of the year to a portfolio that is not rebalanced. Over time, the equity exposure gradually increases, which increases the risk profile. Investing at a risk level higher than an investor's tolerance potentially increases the risk of having emotions drive the investment process.

The second benefit of portfolio rebalancing is providing discipline to an investor to help offset innate behavioral biases. It is important to note that investors are human, humans have emotions, and thus investors have emotions. Peak Capital will even concede that advisors have emotions too. Having a set of rules and guidelines can help reduce representativeness, overconfidence, and "house money" biases, to name just a few. Representativeness is when an expectation is built upon past experiences, i.e. the market was up the last 5 years; it should continue to go up. Overconfidence is placing too high a value on their predictive powers, i.e., I made a great investment move and I will be able to continue that success in the future. "House money" refers to a reduction in risk aversion when investing or holding onto gains, i.e., letting your winnings ride at the Blackjack table. Rebalancing rules can help temper emotional reactions to both positive and negative market conditions. For a further read into behavioral economics, we would recommend a research paper by Jodi N Beggs: "Homer Economicus or Homer Sapiens?: Behavioral Economics in The Simpsons." This paper takes a deeper dive into behavioral finance utilizing examples from The Simpsons.

Even though rebalancing a portfolio back to target weights is not a return maximization strategy, rebalancing can increase portfolio returns in an oscillating market. For example, the chart below illustrates the performance of $100,000 that was invested on January 1, 2001 to December 31, 2016 in a 60% Stock and 40% Bond portfolio. This time period begins with the internet crash, subsequent bull market until the housing market crash of 2008, and concludes with a seven year bull market. The portfolio that was rebalanced at the end of every calendar year had a final value of ~$235,900 compared to ~$218,900 for the non-rebalanced portfolio.

For the portfolio that was not rebalanced, the equity exposure declined to 47% and 44% at the end of 2002 and 2008, respectively. Effectively, the non-rebalanced portfolio was under-allocated to equities after bear markets resulting in the portfolio trailing the performance of the rebalanced portfolio.

Taking a $100,000 and investing in 2009 at the start of the most recent bull market, it is clear that the portfolio that was not re-balanced performed better. In a trending market, either up or down, a rebalanced portfolio will trail the performance of a portfolio that is not rebalanced. In this example, the portfolio that was not rebalanced ended 2016 with a value of ~$228,500 in comparison to a value of ~$217,600 for the rebalanced portfolio.

Even though these are simplistic examples utilizing only two asset classes, S&P 500 and a broad bond market index, they illustrate the value of portfolio rebalancing. Full performance tables and values are available at the end of this paper. The primary benefit of portfolio rebalancing is to re-align the risk of the portfolio with the ability to enhance returns in a volatile market.

A well-diversified portfolio will include several different asset classes (stocks, bonds, cash etc.) that will have different return characteristics. In addition, these different asset classes will hopefully have differing correlations to one another, meaning that all of the investments do not move in the same direction at the same time. Rebalancing a portfolio allows an investor to capture these gains derived from differing volatility and correlations amongst asset classes. Illustrating the gains that can be derived from regularly rebalancing a portfolio, we will explore the performance of a portfolio that is invested equally in two uncorrelated companies: Blue and Red.

As we notice from the chart above, Blue and Red move in opposite directions (uncorrelated) to one another. During this timeframe, the stock prices moved wildly up and down and ultimately ended at their starting value. If an investor just bought and held Blue and Red with no rebalancing, the investor would have seen no gain in their portfolio. If an initial investment of $5,000 was made into both companies, the final portfolio would still be $10,000. However, if the portfolio was rebalanced at the end of each period back to a 50%/50% mix of Blue and Red, the investor would have ended with a value of ~$42,000 from the same $10,000 initial investment. As long as all of the assets in the portfolio are not perfectly correlated, rebalancing can capture these gains.

The benefits of rebalancing do not come for free. There are costs associated with portfolio rebalancing: transaction costs and taxes. When a portfolio is brought back to its target weightings, this will involve selling the assets that have increased in value and buying assets that have declined in value. Most brokerage firms will charge a commission to buy or sell a stock, bond, mutual fund or ETF. However, transaction costs can be reduced or eliminated by utilizing a brokerage firm that offers no-transaction fee mutual funds or commission-free ETF trades. A well-diversified portfolio of ETFs and mutual funds can be constructed at major brokerage firms (Fidelity, Schwab, Vanguard, etc.) with no transaction costs. The transaction costs of rebalancing can be eliminated by utilizing the products that an investor can trade for free at their respective firm.

The second cost of rebalancing that might not necessarily be avoided is taxes. However, there are methods that can be utilized to reduce the tax drag of portfolio rebalancing. Keep in mind that the process of rebalancing involves selling an asset that has increased in value and purchasing an asset that has declined in value. For those adding monies to their portfolios, the solution is simple and easy: Purchase more of the asset class that declined in value to avoid selling an asset at a gain. Another strategy to lower the impact of capital gains is try to do a majority of rebalancing inside of retirement accounts, thus avoiding capital gains tax. Investors with significant portfolio size, where it is not feasible to add more money to the portfolio or rebalance completely inside of retirement accounts to align to targeted portfolio weights, will have a couple of strategies to lower taxes. The first option would be to take no action, thus avoiding selling, if the portfolio is close to targeted weights. The second option is to match gains and losses in taxable accounts paired with transactions in retirement accounts to bring the portfolio closer to targeted weights, but not exact. These two options are by no means an exhaustive list of strategies to lower the tax impact of rebalancing; the optimal strategy is highly dependent on the investor's personal circumstances.

There are two main methodologies for portfolio rebalancing to rebalance a portfolio back to its set allocation: calendar and percentage of portfolio rebalancing. Calendar rebalancing is as simple as the name; it is done on a predetermined date. Calendar rebalance could be conducted annually, semi-annually, and taken to its most extreme daily. It is important to note that the frequency of portfolio rebalancing is correlated with an increase in costs: transactions, taxes, and your time. The advantage of calendar rebalancing is the ease of implementation; however, the drawback is that between rebalance dates asset classes could deviate significantly.

The second methodology is percentage of portfolio, where a portfolio is rebalanced based upon changes in asset values. For example in our 60/40 portfolio, the decision to rebalance would be dictated by equities increasing or decreasing beyond a targeted range. If a 10% corridor is allowed for equities, the portfolio would be rebalanced if equities increased to 66% or declined to 54% of the portfolio value. 60% +/- 10%(60%). Larger corridors should be allowed for more volatile asset classes (equities) to help reduce the amount of trading required. The advantage of percentage rebalancing is that it minimizes the deviation from the targeted asset allocation. The trade-off is that percentage balancing requires more time monitoring the portfolio.

At Peak Capital, we believe that a blend of the two rebalancing methodologies is optimal. We believe that semi-annual rebalancing with adherence to percentage bands for asset classes best balances the goal of maintaining proper asset allocation while reducing the costs associated with rebalancing. In this blended approach, the portfolio is rebalanced on a set schedule, but only if the asset classes are outside of their threshold ranges. Vanguard's (3) research into optimal rebalancing strategy concludes that there is no significant difference in risk-adjusted returns for calendar, percentage of portfolio, or blended rebalancing methodologies. Peak Capital agrees with Vanguard's conclusion that portfolio rebalancing should be done semi-annually or annually when asset classes are outside of their allocation bands.

In a low return environment, it is important to look for methods to improve upon the returns, or lack thereof, of the market. Portfolio rebalancing can potentially add to the returns of the market, but its primary benefit is to maintain the risk profile of the portfolio. Rebalancing is not a free lunch for improved portfolio outcomes: It is important to acknowledge the costs: transaction fees and taxes. The costs of re-aligning a portfolio can be mitigated through proper implementation. Revisiting the sophisticated wealth equation that Peak Capital developed, portfolio rebalancing is a tool that can be incorporated into the formula:

Wealth =Factors You Control + Investment Return

Even though returns are likely to be meager to modest over the next five to ten years, the market returns can be improved by inputs that investors control: increasing savings and developing a plan to manage your portfolio, minimize taxes, and minimize investment costs. The inputs investors control will be key drivers of wealth.

We hope our Investor's Alpha series is helpful to you, the investor, or to advisors in communicating with your clients. Any questions or feedback is always appreciated.

Adam Hoffman, CFA, CAIA

Performance Charts

  1. Vanguard Group. (2016, December). "Putting A Value On Your Value: Quantifying Vanguard Advisor's Alpha". Retrieved from Vanguard.com
  2. Performance data taken from Vanguard.com for VFINX & VBMFX through 12.31.16.
  3. Vanguard Group. (2015, November). "Best Practices For Portfolio Rebalancing". Retrieved from Vanguard.com

Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.

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: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.

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Tagged: Financial Advisors, Wealth Management
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