Finding Your Balance: Tradeoffs and Decisions in Portfolio Rebalancing
Rebalancing can help investors maintain an asset allocation that aligns with their needs, goals, and risk tolerances. The appropriate approach to rebalancing depends on where an investor sits in the tradeoff between rebalancing costs1 and deviations from the target asset allocation. Evaluating an array of rebalancing methods using four decades of historical data, our recent study “Portfolio Rebalancing: Tradeoffs and Decisions” suggests that rebalancing approaches that deviate from calendar-based trading and instead base rebalancing decisions on portfolio composition may produce better tradeoffs for investors.
WEIGHING YOUR OPTIONS
Reducing rebalancing costs and minimizing deviations from a target allocation represent conflicting goals. More frequent rebalancing may keep a portfolio tightly aligned with its target but at the cost of greater turnover. Less frequent rebalancing may lower costs but lead to larger tracking deviations.
Exhibit 1 illustrates this tradeoff. For a US 60/40 portfolio from 1979 to 2019, rebalancing quarterly produced about twice the turnover—our proxy for rebalancing costs—of rebalancing annually. But with that higher cost came a much lower tracking deviation from the target 60/40 allocation—less than half that experienced with annual rebalancing. Exhibit 1 also shows that calendar-based approaches, while convenient, tend to lead to less efficient rebalancing tradeoffs—higher turnover for a given level of tracking error and vice versa—compared to rebalancing with tolerance bands. As detailed in our paper, further improvements can be gained with tiered approaches that apply different tolerance bands across and within asset classes.
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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is registered as an investment adviser with the U.S. Securities and Exchange Commission (“SEC”) with its primary place of business in the state of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. References to registration with the SEC do not imply any endorsement or approval of the qualifications of the firm, nor do they imply that the firm’s representatives have attained a particular level of skill or training. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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