The DOs and DON’Ts of Portfolio Rebalancing

My HighView partners and I spent quite a bit of time discussing and studying the issue of portfolio rebalancing a decade ago – prior to formally launching the firm and taking on our first client. While it’s not the sexiest of investment topics, it’s an important issue for all investment professionals and owners of large portfolios.

We followed up our initial 2009 work on rebalancing with a much deeper analysis in 2015. This resulted in a research paper (that we’ve never published outside of the firm) documenting all of the work we did, summarizing the existing body of research on the topic, and the key questions we tackled. Here are a few highlights.

Clear purpose

As a purpose-driven firm, every part of our process and every component of client portfolios has a specific purpose. That includes rebalancing. Yet when someone like the late Jack Bogle states that he sees no need for rebalancing, it should prompt the very question of whether it’s even worthwhile.

As a legal fiduciary charged with managing wealth for affluent families and foundations; we spend a lot of time helping clients quantify goals and risk preferences. Given the work we’ve done with clients in this regard, rebalancing is necessary to make sure that client portfolios continue to be structured in a way that is aligned with those goals and risk parameters discussed during our discovery meetings.

Mean reversion

Any form of rebalancing implicitly assumes a belief in mean reversion – i.e. that asset prices that trend strongly in one direction will eventually revert back to more ‘normal’ level. While a well-designed rebalancing method can sometimes result in well-timed trades, it’s not a reliable market-timing tool. But once asset prices have trended significantly in one direction or another, rebalancing should capture much of each asset’s return to more normal performance levels.

Momentum

The momentum effect refers to the tendency of asset prices that have moved up or down for some time (i.e., 6-12 months) to continue moving in the same directly in the short-term future. While it’s not a factor in whether or not to rebalance, the long-term persistence of this momentum effect can influence how you rebalance. In other words, rebalancing too often can cut off the benefits of momentum – reducing total returns – and trigger higher trading costs. Most of the financial advisory industry tends to rebalance on set time frames like quarterly or annually which, in my view, is insufficient to capture the long-term benefits of momentum.

Check often, act seldom

A research paper by Gobind Daryanani – Opportunistic Rebalancing: A new paradigm for wealth managers – made a couple of interesting observations. First, Daryanani suggests checking portfolios frequently (i.e. bi-weekly) to assess if rebalancing is necessary. The author noted, however, that this should be combined with moderately wide tolerance thresholds. Secondly, this paper supports the idea of infrequent rebalancing; avoiding more frequent triggers based on set time frames. Setting tolerance bands (the breach of which triggers rebalancing) is key to establishing clear rules while keeping frequency down.

Striking a balance

Our analysis suggests that rebalancing every 2-3 years on average (over time) is likely to be sufficient. Accordingly, a rebalancing method that involves frequent monitoring but infrequent action should nicely balance the goal of controlling risk exposure with capturing the benefits of momentum.

HighView is an experienced fiduciary portfolio management firm committed to investor transparency. We would be happy to discuss our goals-based investment approach with you and your professional advisors.

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