Rebalancing Act: Handling Client Investment Portfolios the Right Way

Financial advisors recognize the importance of client investment portfolio rebalancing, but most would likely welcome some fresh ideas on the process.

That's not say the process doesn't work. Portfolio rebalancing - the regular portfolio tracking process that steers asset classes to optimal investment allocations - not only reduces risk (its primary goal), it also improves investment returns.

In a recent white paper, "Portfolio Rebalancing: How to Pursue Growth and Manage Risk," Anil Suri, a managing director at Merrill Lynch Wealth Management, shows that a regularly rebalanced investment portfolio outperforms an unbalanced one, with the former showing less volatility and stronger portfolio gains.

Here's how Suri describes the process: "To keep the amounts of stocks, bonds and cash in sync with the targeted percentages, you should consider periodic adjusting. This alignment process is known as 'portfolio rebalancing.' It's a critical and often overlooked maintenance step."

By rebalancing on a systematic basis, Suri says your investments may be more likely to align with your goals. "Rebalancing also may help investors avoid trading on emotion," he adds. "As markets or investments soar or fall, many investors succumb to fears that they may be missing an opportunity or risking their principal. Systematic rebalancing can help investors focus on the value of their entire portfolio and not just individual performance. In fact, research shows that investors could improve returns by as much as 5% if they don't give in to reactive behavior like impulsive trading or buying high and selling low."

In a separate white paper, "Best Practices For Portfolio Rebalancing" by Vanguard Research, money managers Yan Zilbering, Colleen M. Jaconetti and Francis M. Kinniry Jr. emphasize the importance of prioritizing risk management in a portfolio rebalancing campaign.

"The primary goal of a rebalancing strategy is to minimize risk relative to a target asset allocation, rather than to maximize returns," the study researchers state. "Over time, asset classes produce different returns that can change the portfolio's asset allocation. To recapture the portfolio's original risk-and-return characteristics, the portfolio should therefore be rebalanced."

What may not be as important to the process is trying to time portfolio rebalancing right.

"In theory, investors select a rebalancing strategy that weighs their willingness to assume risk against expected returns net of the cost of rebalancing," the Vanguard study notes. "Vanguard research has found that there is no optimal frequency or threshold for rebalancing, since risk-adjusted returns do not differ meaningfully from one rebalancing strategy to another."

As a result, the Vanguard study concludes that for most broadly diversified stock and bond fund portfolios (assuming reasonable expectations regarding return patterns, average returns, and risk), "annual or semiannual monitoring, with rebalancing at 5% thresholds, is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved."

To get the job done right, investment advisors are increasingly depending on financial technology tools to handle their clients' portfolio rebalancing needs.

"The best advisors are embracing technology to rebalance portfolios," says Larry Miles, principal at AdvicePeriod, in Los Angeles. "If you're not using technology to rebalance your portfolios, you are costing yourself and your clients money.

"Without technology tools, advisors only have time to rebalance once, or maybe twice a year," he adds. "But in volatile markets, rebalancing should often be done more frequently."

In addition to risk, portfolio rebalancing programs also aim to minimize client investment tax burdens.

"Overall, the trends in rebalancing we've experienced have been toward rebalancing based on tolerance bands and avoiding capital gains," notes Dan Miller, vice president, relationship management at Envestnet Tamarac in the Seattle area.

Miller says advisors will typically set tolerance bands to trigger rebalancing when an assets drifts 20% in either direction from its target. "Historically, advisors have rebalanced every six months or once a year, but with the new portfolio management tools and competition from robotics tools that preach discipline in portfolio management, we are hearing that more traditional RIAs want to adopt a tolerance-based approach," he says.

Managing unrealized gains within portfolios, given the bull run the markets have been on of late, is another big topic. "Many RIAs want to avoid making their clients pay taxes unnecessarily, and so they will limit the amount of gains they incur when rebalancing," Miller explains. "They do this by looking actively to harvest losses to offset realized gains, holding onto highly appreciated securities in lieu of selling them and buying a model security, and by deploying an asset location strategy that treats multiple accounts with different tax statuses owned by the same client as one portfolio and looks to locate high growth securities in Roth and non-taxable accounts."

While automated rebalancing programs can be of great assistance to investors, customization often plays a key role in the process, says John Voltaggio, managing wealth advisor at Northern Trust Wealth Management.

"For example, an investor may be a corporate insider with a large concentrated position in his or her employer stock and may be limited in terms of diversification due to corporate and SEC imposed restrictions," Voltaggio says. "In those cases, the non-concentrated portion of the portfolio needs to be uniquely crafted to complement the concentrated position."

An investor's future charitable giving or wealth transfer plans may also impact the rebalancing process, Voltaggio states. "Charitable giving, for example, can provide an opportunity for tax-efficient diversification and rebalancing. It's also important for an investor and his or her advisor to understand the rationale for different target allocations among various entities in an investor's portfolio. For example, an investor's personal retirement portfolio will likely have a different target allocation than a trust established for grandchildren or a private charitable foundation."

Some money managers say the key to a successful portfolio rebalancing strategy is to focus on correlation, particularly negative correlation

"Negative correlations are a positive when balancing out an investment portfolio, but when most people speak about correlations and looking for negative correlations, it's typically in the public markets," says Yuen Yung, CEO at Casoro Capital, a real estate investment company near Austin, Texas.

Yung says that as more and more information becomes available in a technology-heavy world, it's harder to find negative correlation. "But it's time to start looking for the negative correlation in the private markets as well as the public markets," he says. "Things like real estate, life settlements, or new technologies can give portfolios great negative correlation, but it's not a topic that you see people talk about. They don't understand it, can't find it, or their advisors don't share it with them because they usually don't get paid on it and it's hard to research."

"Investors should really start to learn more about what else is out there in the non-publicly traded world because they're missing out," he adds.

Today's version of the venerable client portfolio rebalancing plan is more complicated and more reliant on technology and data, and that's O.K..

With trillions of investor assets on the table, money managers need to up their game and provide better data, and better advice, before embarking on any portfolio rebalancing campaign.

The good news is that advisors know this, and are already taking steps to get the job done.