Portfolio rebalancing
Portfolio rebalancing is the process of buying, selling, or otherwise adjusting investments within a portfolio to restore its asset allocation to predetermined target weights. Rebalancing is used to maintain the intended relationship between different asset classes, securities, or investment strategies as changes in market prices cause portfolio weights to diverge from their target allocations.
Portfolio rebalancing is a fundamental component of Portfolio management and Asset allocation. It may be performed at predetermined intervals, when asset weights exceed specified tolerance bands, or in response to changes in an investor's objectives, risk tolerance, or investment horizon.
Rebalancing generally involves reducing exposure to assets that have increased above their target allocation and increasing exposure to assets that have fallen below their target allocation. The process does not necessarily seek to predict future market movements; instead, it maintains the portfolio according to a predefined investment policy.
Objectives
The principal objectives of portfolio rebalancing are to:
- maintain target asset allocations;
- control portfolio risk;
- prevent excessive concentration;
- maintain consistency with an investment strategy;
- adjust the portfolio following significant market movements;
- align investments with changing investor objectives.
Methods
Portfolio rebalancing may be performed using several methods, including:
- calendar-based rebalancing;
- threshold-based rebalancing;
- hybrid rebalancing;
- cash-flow-based rebalancing.
Calendar-based rebalancing
Calendar-based rebalancing occurs at predetermined intervals, such as monthly, quarterly, semiannually, or annually.
Under this approach, portfolio weights are reviewed and adjusted according to a fixed schedule.
Threshold-based rebalancing
Threshold-based rebalancing occurs when an asset class deviates from its target allocation by a specified amount.
For example, a portfolio may have a target equity allocation of 60% and a permitted deviation of 5 percentage points. Rebalancing would occur if equity exposure falls below 55% or rises above 65%.
Hybrid rebalancing
Hybrid rebalancing combines calendar-based reviews with predetermined allocation thresholds.
The portfolio is reviewed periodically, but transactions are undertaken only when deviations exceed specified limits.
Cash-flow-based rebalancing
Cash-flow-based rebalancing uses new contributions, dividends, interest income, or withdrawals to move portfolio allocations toward their target weights without necessarily selling existing investments.
This approach may reduce transaction costs and taxable capital gains.
Calculation
The target value of an asset within a portfolio can be calculated as:
The amount that must be bought or sold can then be expressed as:
A positive result indicates that additional investment is required, while a negative result indicates that part of the existing position may need to be reduced.
Example
Suppose an investor establishes the following target allocation:
| Asset class | Target allocation |
|---|---|
| Equities | 60% |
| Bonds | 30% |
| Cash | 10% |
If the total portfolio is worth US$100,000, the target equity value is:
Suppose equities subsequently increase in value and represent 70% of the portfolio.
The investor may sell part of the equity holdings and allocate the proceeds to bonds or cash to restore the portfolio toward its target allocation.
Relationship with asset allocation
Asset allocation establishes the target distribution of investments among different asset classes.
Portfolio rebalancing maintains that distribution after market movements or changes in portfolio value cause actual allocations to diverge from the targets.
Relationship with portfolio management
Portfolio management includes the broader process of constructing, monitoring, and adjusting an investment portfolio.
Portfolio rebalancing is one of the principal mechanisms used to maintain portfolio risk and investment objectives over time.
Relationship with passive management
Passive management frequently requires rebalancing when the underlying benchmark changes its constituents or weights.
Index-tracking funds may therefore adjust their holdings to maintain alignment with the benchmark.
Relationship with active management
Active management may also involve rebalancing when portfolio managers change security weights based on valuation, market conditions, risk assessments, or investment expectations.
Unlike systematic rebalancing based solely on target weights, active managers may deliberately maintain positions that differ substantially from benchmark or policy allocations.
Costs and taxes
Portfolio rebalancing may generate:
- brokerage and transaction costs;
- bid-ask spreads;
- market-impact costs;
- capital gains taxes;
- management and administrative costs.
Investors may therefore consider tax implications and transaction costs when determining the frequency and method of rebalancing.
Advantages
Portfolio rebalancing can maintain a portfolio's intended risk profile, reduce excessive concentration, impose investment discipline, and ensure continued alignment with long-term financial objectives.
It can also encourage systematic buying of assets that have declined relative to their target weights and selling of assets that have increased substantially.
Limitations
Rebalancing does not guarantee higher returns and may cause investors to sell assets that subsequently continue to appreciate or purchase assets that continue to decline.
Frequent rebalancing may also increase transaction costs, taxes, and administrative complexity.
Importance
Portfolio rebalancing is a fundamental portfolio management process because market movements continuously change the relative weights of investments. By periodically restoring target allocations or maintaining predefined allocation ranges, investors can control portfolio risk and maintain consistency with their long-term investment strategy.