Portfolio Management: Our Approach To Portfolio Rebalancing

Portfolio Management:  Our Approach To Portfolio Rebalancing

For every investment organization, portfolio management plays a key role in the implementation and execution of any strategy.  Portfolio management can mean many things.  In our opinion, one of the most critical activities involved in portfolio management is rebalancing.  Rebalancing is a term used to describe the trading activity that is meant to bring a portfolio’s various asset classes in-line with its target.  For example, let’s assume that a portfolio’s target allocation is supposed to be 60% stocks and 40% bonds.  Hypothetically, over the course of a year, the stock market does well and the bond market return is slightly negative.  At the end of the year, that same 60/40 portfolio may actually be allocated closer to 65% stocks and 35% bonds base, thus creating a variance to the target of 5% in both asset classes.  Rebalancing trades would simply look to realign the account back to its target allocations.  This would involve selling 5% of the stock allocation and adding 5% to the bond allocation.

Why would one want to engage in such trading activity?  The simple answer is that rebalancing is one of the most effective ways to control risk in a portfolio.  If implemented effectively, estimates from the research group at Vanguard indicate that rebalancing adds between ~0.25-0.50%/year to a portfolio return versus no action while simultaneously reducing portfolio volatility.  This is because the process of rebalancing is one of the few ways an investor can take advantage of stock and bond price volatility.  In the chart below, we’ve noted the rebalancing activity we’ve conducted in most client accounts during 2020.  We’ll describe how this was done in the paragraphs that follow.

Our Approach To Rebalancing

As with many portfolio decisions, there is no such thing as bad or good, only better or worse.  Over the years, as an investment committee, we’ve continually revisited the question of when to rebalance given the importance of the decision.  Ultimately, we’ve coalesced around a few key concepts:

  1. Let the stock volatility of the account alert us to a potential rebalance price level in the S&P 500.  Given the stock portion of accounts will likely be the most volatile in any given year (relative to either bonds or alternative strategies).
  2. Establish a projected range of outcomes for stocks on a rolling 12 month forward-looking time period.  Many factors will influence the ultimate range we establish as an investment committee.  In “normal” years for the range would look something like +20% or -20% in the S&P 500 from the last rebalance.
  3. Once a potential rebalance level is reached (whether on the upside or downside), we reevaluate the decision incorporating any new information that helped markets get to that point.  New information might include  relative performance of other asset classes, macro economic changes and any relevant technical indicators.
  4. The investment committee discusses/reviews the above information and makes a decision.  Once the decision is made to proceed, execution occurs shortly thereafter.  If the decision is made not to proceed, then a follow-up review meeting is set and the process is repeated.

A feature of our rebalancing process to point out is that this is not a strictly mechanical processes.  Allowing for debate and value assessment to permeate the process is an important facet.  This ensures that we aren’t rebalancing too often or too little.  Again, building in some flexibility to the process is purposeful and is a feature that many other investment firms struggle to incorporate.

In all, the purpose for writing this article was to give you some additional insight into what we are doing and why.  In periods of higher volatility, rebalancing can be a portfolio management decision that can add meaningful return over long periods of time.  We look forward to helping you navigate that journey together.