Rebalancing is an essential component of the portfolio management process. Investors who seek the services of a professional typically have a desired level of systematic risk exposure and thus their portfolio manager has a responsibility to adjust investment holdings to adhere to the clients' constraints and preferences. Although portfolio rebalancing strategies incur transaction costs and tax liabilities, there are several distinct advantages to maintaining the desired target allocation. (See Rebalance Your Portfolio To Stay On Track.)
TUTORIAL: Introduction To Fundamental Analysis
Primarily, as previous mentioned, 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.
Assume that a retiree has 75% of his portfolio invested in risk free assets, with the remainder in equities. If the equity investments triple in value, 50% of the portfolio is now allocated to risky stocks. An individual portfolio manager who specializes in fixed income investments would no longer be qualified to manage the portfolio as the allocation has shifted outside his area of expertise. In order to avoid these unwanted shifts, the portfolio must be regularly rebalanced. Also, the growing portfolio proportion allocated to equities increases the overall risk to levels beyond those which are normally desired by a retiree.
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 formulaic rebalancing is that it is significantly less time consuming for the investor since the latter method is a continuous process.
A preferred yet slightly more intensive approach to implement involves a rebalancing schedule focused on the allowable percentage composition of an asset in a portfolio. 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 35-45% of the portfolio must be allocated to government bonds. When the weight of any one holding jumps outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.
These two rebalancing techniques, the calendar and corridor method, are known as constant-mix strategies because the weights of the holdings do not change.
Determining the range of the corridors depends on the intrinsic characteristics of individual asset classes as different securities possess unique properties that influence the decision. Transaction costs, price volatility and correlation with other portfolio holdings are the three most important variables in determining band sizes. Intuitively, higher transaction costs will require wider allowable ranges to minimize the impact of expensive trading costs.
High volatility, on the other hand, has the opposite impact on the optimal corridor bands; riskier securities should be confined to a narrow range in order to ensure that they are not over or underrepresented in the portfolio. Finally, securities or asset classes that are strongly correlated with other held investments can acceptably have broad ranges since their price movements parallel other assets within the portfolio. (A high-risk security can reduce risk overall. Find out how it works. Refer to Make Your Portfolio Safer With Risky Investments.)
Constant-Proportion Portfolio Insurance
A third rebalancing approach, the constant-proportion portfolio insurance (CPPI) strategy, assumes that as investors' wealth increases, so does their risk tolerance. The basic premise of this technique stems from having a preference of maintaining a minimum safety reserve held in either cash or risk free government bonds. When the value of the portfolio increases, more funds are invested in equities whereas a fall in portfolio worth results in a smaller position toward risky assets. Maintaining the safety reserve, whether it will be used to fund a college expense or be put as a down payment on a home, is the most important requirement for the investor. For CPPI strategies, the amount of money invested in stocks can be determined with the formula:
$ Stock Investments = M * (TA – F)
M – investment multiplier (higher risk tolerance, higher "M")
TA – total portfolio assets
F – allowable floor (minimum safety reserve)
For an example, assume that an individual has an investment portfolio of $300,000, and $150,000 of which must be saved in order to pay for her daughter's university tuition. The investment multiplier is 1.5.
Initially, the amount of funds invested in stocks is $225,000 [1.5*($300,000-150,000)] with the remainder allocated to risk free securities. If the market falls by 20%, the value of the equity holdings will be reduced to $180,000 ($225,000*0.8) while the worth of the fixed income holdings remain at $75,000 to produce a total portfolio value of $255,000. The portfolio would then have to be rebalanced using the previous formula and now only $157,500 would be allocated to risky investments [1.5*(255,000-150,0000)].
CPPI rebalancing must be used in tandem with rebalancing and portfolio optimization strategies as it fails to provide details on the frequency of rebalancing and only indicates how much equity should be held within a portfolio rather than providing a holding breakdown of asset classes along with their ideal corridors. Another source of difficulty with the CPPI approach deals with the ambiguous nature of "M," which will vary among investors.
Portfolio rebalancing provides protection and discipline for any investment management strategy at the retail and professional levels. The ideal strategy will balance out the overall needs of rebalancing with the explicit costs associated with the strategy chosen. (Learn how to follow the efficient frontier to better returns. Check out Modern Portfolio Theory Stats Primer.)
Mutual Funds & ETFsFind out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
ProfessionalsLearn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
ProfessionalsLooking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
InvestingThe recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
InvestingThe further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
Personal FinanceMany advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
Investing BasicsYou can never be sure of what the market will do at any given moment. That’s why a well-diversified portfolio is so important.
Mutual Funds & ETFsDiscover detailed analysis and information about some of the top exchange-traded funds (ETFs) that offer exposure to the investment-grade corporate bond market.
RetirementFind out why you should include balanced funds in your portfolio, including the importance of customizability, diversification and professional management.
Mutual Funds & ETFsLearn more about the top four best-performing mutual funds based on their total percentage investment return for the past 10 years.
Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
Financial advisors who operate as fee-only planners charge a percentage, usually 1 to 2%, of a client's net assets. For a ... Read Full Answer >>
While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>