Asset allocation possesses the potential to help investors manage risk adjusted return. However, portfolio adjustments should not be considered one-off events that occur periodically throughout the year—they should be a process that is constantly managed to achieve optimal results.
By implementing a disciplined rebalancing1 process that consistently monitors a portfolio and fine-tunes it when necessary, advisors are more likely to help their clients manage risk appropriately. At the same time, while rebalancing is a critical portfolio management task, it can pose challenges in terms of costs and timing.
That’s because selling one asset class and buying another incurs transaction costs and has the potential to incur capital gains taxes. It also creates risk around opportunity costs, as it takes time to sell some of the asset class that has risen in value to raise the cash to buy the asset class that has fallen in value, leaving cash uninvested for a period of time.
There are several strategies that financial advisors can employ to stay on track with a rebalancing program while remaining sensitive to timing and cost issues. These include:
- Ongoing monitoring: Rebalancing starts with an ongoing monitoring process. When monitoring is relegated to an event that happens only once or twice a year, you may miss the opportunity to sell positions that have run up, locking in profits for clients and avoiding allocation drift.1 Monitoring can be accomplished via portfolio alerts, rebalancing programs, and apps.
- Establishing allocation bands:2 Implementing a disciplined approach to rebalancing based on allocation drift is important. This kind of systematic approach to rebalancing can help deter risks related to human error. A well-ordered allocation band can prevent assets from moving between high performing investments and poorly performing ones.
- Consider both the costs and benefits:3 It may not be necessary to rebalance all of the way back to the target allocation. Moving part way back may better balance the costs and benefits of rebalancing. For example, if a target fixed income allocation is 30 percent, a “drift” band around that allocation could be 25 to 35 percent. If the allocation drifted up to 35 percent, rebalancing back to 32.5 percent could in some cases yield a better result than rebalancing all of the way back exactly to 30 percent.
By implementing and adhering to a systematic rebalancing program, advisors can position client portfolios to potentially enhance risk-adjusted returns and manage downside risk. There are a number of approaches that have merit – be sure that whatever approach you choose has the potential to achieve the results your clients deserve. More information on tax management is available here.
Rebalancing may involve tax consequences.
1 Allocation drift refers to differences in an account’s actual asset allocation compared to its target allocations. For example, a portfolio may start off with a 50% allocation to equities and a 50% allocation to fixed income. Because these investments will inevitably perform differently over time, the actual allocations will begin to drift away from the starting or target weights. If several months down the road this same portfolio had actual allocations of 55% equities and 45% fixed income, there would be 5% of allocation drift associated with each asset class.
2 Allocation bands: A targeted range of asset distribution based on risk tolerance, time horizon and investment objectives.
3 Consider both the costs and benefits. Generally speaking, it is more costly to move all the way back to the initial target allocation. Moving only part way back may serve to mitigate the costs and increase the benefits of rebalancing.
Natixis Global Asset Management does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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