Rebalancing is an important part of the portfolio management process. Investors seeking professional services often have the required level of exposure to systemic risk, and it is therefore the responsibility of their portfolio managers to adjust investment holdings to comply with client constraints and preferences.
While portfolio rebalancing strategies incur transaction costs and tax liabilities, maintaining an ideal target allocation has several distinct advantages.
- Portfolio rebalancing provides protection and discipline for any investment management strategy at retail and professional levels.
- Rebalancing enables investors to ensure that their portfolios are aligned with their expected risk profile.
- Strategies include Calendar Rebalance, Portfolio Percentage Rebalance, and Fixed Percent Portfolio Insurance.
First, portfolio rebalancing prevents investors from being overly exposed to bad risks. It also ensures that portfolio risk remains within the manager’s area of expertise.
Suppose a retiree invests 75% of his portfolio in risk-free assets and the rest in stocks. If the value of the equity investment tripled, now allocate 50% of the portfolio to risky stocks. Individual portfolio managers who specialize in fixed income investing will no longer be eligible to manage portfolios, as allocations have moved outside of their area of expertise. To avoid these unnecessary changes, the portfolio must be rebalanced regularly.
In addition, an increasing proportion of the portfolio allocated to stocks increases overall risk beyond what retirees typically expect.
There are several basic rebalancing options that retail or institutional investors can take advantage of to create an optimal investment process.
Calendar rebalancing is the most basic method of rebalancing. The strategy simply involves analyzing the investment holdings in the portfolio at predetermined intervals and adjusting to the original allocation with the desired frequency. Monthly and quarterly evaluations are usually preferred, as weekly rebalancing would be prohibitively expensive, and an annual approach would allow for too much intermediate portfolio drift. The ideal frequency of rebalancing must be determined based on time constraints, transaction costs, and allowable deviations.
A question many investors ask has to do with the ideal time frame for rebalancing their portfolios. A 2019 Vanguard study tracked portfolios containing 60/40 stock and bond combinations that were monthly, quarterly, yearly and never rebalanced. The researchers found that there was “little difference” in the performance of the portfolios over the time frames involved.
A major advantage of calendar rebalancing over formulaic rebalancing is that it is significantly less time-consuming for investors because the latter method is a continuous process.
Portfolio Percent Rebalancing
A preferred but slightly more intensive method of implementation involves a rebalancing program that focuses on the allowable percentage composition of assets in the portfolio. Each asset class or individual security is assigned a target weight and corresponding tolerance range.
For example, an allocation strategy might include a requirement to hold 30% emerging market equities, 30% domestic blue chip stocks, and 40% government bonds, with a range of +/- 5% for each asset class. Basically, both emerging market and domestic blue chip holdings can fluctuate between 25% and 35%, while 35% to 45% of the portfolio must be allocated to government bonds. When any holder’s weight falls outside the allowable range, the entire portfolio is rebalanced to reflect the initial target composition.
These two rebalancing techniques—calendar and corridor—are known as constant-mixing strategies because the weights of holdings do not change.
Determining the extent of the corridor depends on the intrinsic characteristics of each asset class, as different securities have unique properties that influence decision-making. Transaction costs, price volatility, and correlation with other portfolios are the three most important variables in determining the size of the band. Intuitively, higher transaction costs will require a wider allowable range to minimize the impact of expensive transaction costs.
On the other hand, high volatility has the opposite effect on the optimal corridor range – riskier securities should be limited to a narrow range to ensure they are not over- or under-represented in the portfolio. Finally, securities or asset classes that are closely related to other held investments can have broad scope because their price movements parallel other assets in the portfolio.
Equal Proportion Portfolio Insurance
A third approach to rebalancing, the Constant Proportion Portfolio Insurance (CPPI) strategy, assumes that as investors’ wealth increases, their risk tolerance also increases. The basic premise of this technique stems from the tendency to maintain a minimum safety reserve in the form of cash or risk-free government bonds. When the value of the portfolio increases, more money is invested in equities, while the decrease in the value of the portfolio leads to a decrease in risky asset positions. Maintaining a safety stockpile, whether it’s for college expenses or a down payment on a home, is the most important requirement for investors.
For the CPPI strategy, the amount to invest in stocks can be determined by the following formula: