Rebalancing

What Is Rebalancing?

Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk.

For example, say an original target asset allocation was 50% stocks and 50% bonds. If the stocks performed well during the period, it could have increased the stock weighting of the portfolio to 70%. The investor may then decide to sell some stocks and buy bonds to get the portfolio back to the original target allocation of 50/50.

How Rebalancing Works

Primarily, portfolio rebalancing safeguards the investor from being overly exposed to undesirable risks. Secondly, rebalancing ensures that the portfolio exposures remain within the manager's area of expertise. Often, these steps are taken to ensure the amount of risk involved is at the investor's desired level. As stock performance can vary more dramatically than bonds, the percentage of assets associated with stocks will change with market conditions. Along with the performance variable, investors may adjust the overall risk within their portfolios to meet changing financial needs.

"Rebalancing," as a term, has connotations regarding an even distribution of assets; however, a 50/50 stock and bond split is not required. Instead, rebalancing a portfolio involves the reallocation of assets to a defined makeup. This applies whether the target allocation is 50/50, 70/30 or 40/60.

While there is no required schedule for rebalancing a portfolio, most recommendations are to examine allocations at least once a year. It is possible to go without rebalancing a portfolio, though this would generally be ill-advised. Rebalancing gives investors the opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet experienced such notable growth.

Calendar rebalancing is the most rudimentary rebalancing approach. This strategy simply involves analyzing the investment holdings within the portfolio at predetermined time intervals and adjusting to the original allocation at a desired frequency. Monthly and quarterly assessments are typically preferred because weekly rebalancing would be overly expensive while a yearly 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 drift. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for the investor since it involves less trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly.

A more responsive approach to rebalancing focuses on the allowable percentage composition of an asset in a portfolio - this is known as a constant-mix strategy with bands or corridors. Every asset class, or individual security, is given a target weight and a corresponding tolerance range. For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips and 40% in government bonds with a corridor of +/- 5% for each asset class. Basically, emerging market and domestic blue chip holdings can both fluctuate between 25% and 35%, while 35% to 45% of the portfolio must be allocated to government bonds. When the weight of any one holding moves outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.

The most intensive rebalancing strategy commonly used is constant proportion portfolio insurance (CPPI) is a type of portfolio insurance in which the investor sets a floor on the dollar value of their portfolio, then structures asset allocation around that decision. The asset classes in CPPI are stylized as a risky asset (usually equities or mutual funds) and a conservative asset of either cash, equivalents, or treasury bonds. The percentage allocated to each depends on a"cushion" value, defined as the current portfolio value minus some floor value, and a multiplier coefficient. The greater the multiplier number, the more aggressive the rebalancing strategy. The outcome of the CPPI strategy is somewhat similar to that of buying a synthetic call option that does not use actual option contracts. CPPI is sometimes referred to as a convex strategy, as opposed to a "concave strategy" like constant-mix. 

Rebalancing Retirement Accounts

One of the most common areas investors look to rebalance are the allocations within their retirement accounts. Asset performance impacts the overall value, and many investors prefer to invest more aggressively at younger ages and more conservatively as they approach retirement age. Often, the portfolio is at its most conservative once the investor prepares to draw out the funds to supply retirement income.

Rebalancing for Diversification

Depending on market performance, investors may find a large number of current assets held within one area. For example, should the value of stock X increase by 25% while stock Y only gained 5%, a large amount of the value in the portfolio is tied to stock X. Should stock X experience a sudden downturn, the portfolio will suffer higher losses by association. Rebalancing lets the investor redirect some of the funds currently held in stock X to another investment, be that more of stock Y or purchasing a new stock entirely. By having funds spread out across multiple stocks, a downturn in one will be partially offset by the activities of the others, which can provide a level of portfolio stability.

Smart Beta Rebalancing

Smart beta rebalancing is a type of periodic rebalancing, similar to the regular rebalancing that indexes undergo to adjust to changes in stock value and market capitalization. Smart beta strategies take a rules-based approach to avoid the market inefficiencies that creep into index investing due to the reliance on market capitalization. Smart beta rebalancing uses additional criteria, such as value as defined by performance measures like book value or return on capital, to allocate the holdings across a selection of stocks. This rules-based method of portfolio creation adds a layer of systematic analysis to the investment that simple index investing lacks. 

Although smart beta rebalancing is more active than simply using index investing to mimic the overall market, it is less active than stock picking. One of the key features of smart beta rebalancing is that emotions are taken out of the process. Depending on how the rules are set up, an investor may end up trimming exposure to their top performers and increasing exposure to less stellar performers. This runs counter to the old adage of letting your winners run, but the periodic rebalancing realizes the profits regularly rather than trying to time market sentiment for maximum profit. Smart beta can also be used to rebalance across asset classes if the proper parameters are set. In this case, the risk-weighted returns are often used to compare different types of investments and adjust exposure accordingly.