Types of rebalancing strategies

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.

Primarily, 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. (For more, see "Rebalance Your Portfolio to Stay on Track.")

There are several basic rebalancing options that either retail or institutional investors can utilize to create an optimal investment process.

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% to 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. To find out how it works, refer to "Make Your Portfolio Safer With Risky Investments.")

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:

$\begin{aligned} &\$\text{ Stock investments} = M \times (TA - F)\\ &\textbf{where:}\\ &M=\text{investment multiplier (higher risk tolerance, higher "M")}\\ &TA=\text{total portfolio assets}\\ &F=\text{allowable floor (minimum safety reserve)}\\ \end{aligned}$​$ Stock investments=M×(TA−F)where:M=investment multiplier (higher risk tolerance, higher "M")TA=total portfolio assetsF=allowable floor (minimum safety reserve)​

For 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.