As a reminder, portfolio rebalancing consists of periodically buying or selling assets in a portfolio to maintain the original or desired level of asset or risk allocation in the portfolio. For example, if the original target asset allocation was 50% of shares and 50% of the bonds, and the shares performed well over this period, this could increase the weight of the shares in the portfolio to 70%. The investor may then decide to sell some shares and purchase bonds to return the portfolio to its original 50/50 allocation.

How rebalancing works

First of all, restoring the balance of the portfolio protects the investor from excessive exposure to undesirable risk. Second, rebalancing ensures that portfolio exposures remain within the management’s expertise. Often, these steps are taken to ensure that the risk is associated with the level desired by the investor. Since the performance of shares may differ significantly more than bonds, the percentage of assets associated with shares will change depending on market conditions. Along with the performance variable, investors can adjust the overall risk in their portfolios to meet changing financial needs.

Rebalancing gives investors the opportunity to sell at a high level and buy at a low level, benefiting from high-yield investments and reinvesting them in areas where such significant growth has not yet been seen. Calendar re-balancing is the most basic approach to balancing. This strategy consists of analyzing investments in the portfolio at specific intervals and adapting to the original allocation at the desired frequency. Usually monthly and quarterly intervals are preferred. The ideal rebalancing frequency should be determined based on time limits, transaction costs, and allowable drift. The main advantage of calendar balancing compared to more responsive methods is that the process is much less time-consuming and costly because it involves fewer transactions and predetermined dates. The downside, however, is that it doesn’t allow you to restore balance at other times, even if the market is moving significantly.

A more responsive approach to rebalancing focuses on the permissible percentage of assets in the portfolio – this is known as a strategy of continuous connection with bands or corridors. Each asset class or individual security is assigned a target weight and an appropriate tolerance range. For example, the allocation strategy may include a requirement to hold 30% of shares in emerging markets, 30% in domestic blue chips and 40% in government bonds with a +/- 5% corridor for each asset class. In general, both emerging markets and national blue chip packages can range between 25% and 35%, and 35-45% of the portfolio must be allocated to government bonds. When one of the weights exceeds the allowable range, the entire portfolio is rebalanced to reflect the initial target composition.

The most intensive common balancing strategy is a fixed portfolio propotion insurance (CPPI) is a type of portfolio insurance in which the investor sets a lower limit on the value of his portfolio and then organizes the allocation of assets around this decision. Asset classes in CPPI are stylized as risky assets (usually shares or mutual funds) and conservative monetary assets, equivalents or treasury bonds. The percentage assigned to each depends on the value of the “cushion”, defined as the current value of the portfolio minus a certain value and a multiplier factor. The higher the number of multipliers, the more aggressive the balancing strategy is. The result of the CPPI strategy is somewhat similar to buying a synthetic call option that does not use real option contracts. CPPI is sometimes referred to as convex strategy, as opposed to “concave strategy” such as continuous mixing.

Portfolio rebalancing – an emotional challenge for investors

Restoring balance is an emotional challenge. People are ready to invest more money in investments that are doing well at the expense of those that are not attractive. Making reallocation decisions that contradict the emotional current can be difficult if you take into account the right time to restore balance.

Systematic restoration of balance can change the narrative – a strong framework that uses strategy turning points to signal the need to equalize exposure. When the exposure with better results reaches the upper activation point, the sales decision is activated. When the exposure of the underperforming assets reaches the lower activation point, the buy decision is activated.

Rapid market volatility in 2020 was an excellent test for systematically restoring portfolio balance. Let’s look at a hypothetical portfolio of 60% shares and 40% bonds, financed with USD 1000 in December 2018.

If the portfolio were not rebalanced, global equity growth in 2019 would increase capital allocation to almost 64% by the end of the year, not for long. A bear market in February and March would reduce this capital exposure to 54%. An unbalanced portfolio would be outweighed by exposure to shares at the top of the market and underweighted exposure in the lower adjustment areas.

Systematic restoration of balance would soften these exposures. Applying a 3% start balancing point would reduce capital exposure when the weight reaches 63%, providing a financial cushion in a sales situation. In a market correction, the portfolio would buy cheaper shares because the allocation fell below 57% on 9, 12 March and 23 March. These adjustments would allow a greater share of the rebound. By March 31, rebalancing would add almost half a percent (42 basis points), minus transaction costs, to the initial $ 1,000 investment.

Framework for restoring portfolio balance

Systematic rebalancing of the portfolio has shown the ability to remove human emotions and the calendar from the rebalancing pattern. What determines the numbers in the equation: when and how much to rebalance the portfolio again?

The most important input is risk tolerance, volatility, asset class correlations, and transaction costs – these are not static. For example, transaction costs have been the subject of much discussion during a recent sale, given the lack of liquidity that has captured the markets and increased trading costs. If nothing else changed, higher transaction costs would lead to broader rebalancing mechanisms – because balancing would be more expensive.

Volatility has also changed, causing larger allocation fluctuations. Although it has fallen from the tops, it is still more than twice as high as normal. Just greater volatility would support narrower trigger points than in a normal environment. Changing input data usually cancel each other out, and the trigger point balancing structure still applies.
Transaction costs also influence the decision on what degree of weight deviation in the portfolio triggers a return to strategic goals while restoring balance. Observation shows that rebalancing the portfolio is best done in the “halfway” upper or lower deviation. The benefits of rebalancing – in terms of reducing the portfolio tracking error – are rising geometrically. On the other hand, transaction costs are rising in a straight line – rebalancing the target with a 2% deviation costs twice as much as rebalancing costs with a 1% deviation. Net result: the benefits of reallocating allocation for strategic purposes are not justified by costs.

Systematic rebalancing not only for solutions on a target date

Rebalancing is a key component of the project’s target date, keeping glide paths in close proximity to their strategic allocations over time. Given the long time horizon of target investors, systematic rebalancing can help maintain target date allocation over time, reinforcing proven investment principles. Systematic rebalancing does not have to be limited to solutions on a target date. This makes sense for all types of multi-asset strategies.

There are many ways to manage risk, including tactical asset allocation and adjusting strategic allocations. However, in the case of long-term investors who do not use these tools, systematic restoration of portfolio balance offers an attractive way to manage portfolio risk of many assets – maintaining strategic asset allocation, preventing time risk, systematic use of market dislocation to increase value and removing emotions from the investment equation.