When Should You Rebalance Client Portfolios?

Duane McDonald, ChFC®, AIF®, RICP®

Duane McDonald, ChFC®, AIF®, RICP®

04.15.20 in Wealth Planning & Investing

Wealth Management

It’s always a challenging question, but the current market volatility brings it particularly into focus. Normally, like many advisors, you may prefer calendar rebalancing—quarterly, semiannually, or annually. And, whatever the time frame you set, it’s likely that you’ve recently addressed the need for rebalancing during your end-of-year portfolio reviews. But now, given the significance of the economic downturn and widespread uncertainty regarding where the markets will go in coming months, what should you do?

Is it time to reevaluate and rebalance client portfolios? The short answer is probably yes. When markets are this disrupted, portfolio allocations can quickly become significantly distant from their target weightings. To give you a framework for an off-cycle rebalance due to market volatility, I’ll review the rationale for rebalancing, as well as important strategic considerations.

Why Should You Rebalance?

Rebalancing supports an investment plan no matter what the market is doing. Key elements of rebalancing include the following:

  • Managing risk

  • Locking in gains

  • Harvesting losses in taxable accounts

  • Removing emotional elements of investing

Managing risk. The rebalancing process helps manage risk by maintaining a client’s original investment objective and risk profile. Assuming the client’s risk tolerance is unchanged, a rebalance during market turmoil such as we have seen over the past weeks can provide long-term advantages. A recent article from Morningstar (“Here’s Why You Should Rebalance (Again)”) does a good job of explaining the advantages of a rebalance due to market volatility. According to Morningstar’s historical analysis, portfolios that weren’t rebalanced during a bear market experienced a longer recovery period.

Locking in gains. Rebalancing locks in gains on appreciated investments. Often, this can go against clients’ natural instincts. In up markets, they may ask, “Why should I sell my winners?” But the discipline of rebalancing forces investors to sell high and buy low—exactly what makes investing successful.

Harvesting losses in taxable accounts. Although this process takes more effort, the tax alpha of harvesting losses can add real value. Essentially, you create tax losses by selling losing positions. But, in order for investors to net those losses against gains, you must not trade back into the losing position for 30 days. Rather than sit in cash, many advisors will buy an alternative investment, such as an exchange-traded or index fund to maintain market exposure. On day 31, you can sell the alternative security and move back to the original position (assuming it is still the highest-conviction holding for that part of the allocation). 

Removing emotional elements of investing. In a market downturn, emotional selling is a natural impulse. But selling when an investment is down obviously results in locking in losses rather than gains, which may not be desirable unless you wish to harvest losses. Rebalancing can help reduce the emotional component of investing—it provides both structure and discipline in the investing and asset allocation process. A consistent, well-documented strategy for rebalancing should help protect investors against a hasty decision to change a long-term investment strategy.

Strategic Considerations

Keep these considerations in mind when rebalancing:

“Hybrid” approach. While an annual rebalance is typically sufficient, you may wish to adjust the timeline as appropriate for each portfolio. A hybrid version of an annual rebalance is a rolling 13-month rebalance. Each portfolio is rebalanced on the 13-month anniversary of account inception or the last rebalance date. Because this method moves the rebalance period over time, rather than setting it at year-end, most gains realized will be long term.

Rebalancing thresholds. Many advisors use a threshold of above 3 percent or above 5 percent to rebalance client portfolios. You can also use a dollar amount as the threshold to limit smaller transactions and unnecessary costs. Although many advisors check thresholds annually, extreme periods of market volatility can offer an interim opportunity to review asset weightings versus thresholds.

Client objectives. If a client’s stated investment objective or tolerance for risk has changed, then a move to a more appropriate allocation should be considered. For instance, a client’s nearness to retirement may affect the new target allocation.

Tax considerations. Selling appreciated assets can trigger a tax bill, so you need to carefully evaluate your client’s tax situation when rebalancing.

Retirement accounts. Rebalancing can also be a helpful tool in retirement income planning, particularly during the withdrawal phase. If you’re going to sell assets anyway, you can use the opportunity to realign the overall holdings to the target. Advisors using the bucket approach might want to sell appreciated positions to fund client cash needs or to make required minimum distributions.

Cash on the sideline. If clients have cash on the sideline they wish to add to their portfolio, the contributions can be added proportionately to the most underweight investments, thus bringing the allocation back into balance.

Dividends. Should you reinvest dividends or have them go into the cash sweep account? By having dividends go into cash, you may be able to use the money to balance out asset classes and avoid selling off winners.

Withdrawals. Withdrawals can throw off your allocation. Try to plan ahead and leave money in cash to cover foreseeable withdrawals and your advisory fee. When you need to raise funds for a withdrawal, consider selling off overweighted positions.

Transaction charges. These expenses can be costly, so be sure to weigh the benefits of rebalancing against the costs.

Alternative investments. Assets like real estate, managed futures, and hedge funds can pose a rebalancing challenge. While it may be difficult to add or trim these positions due to the liquidity or subscription issues, you can adjust other positions in a way to keep the desired exposures. Or simply exclude illiquid positions from consideration during a rebalance.

The Long-Term Benefits of Rebalancing

Your plan to rebalance client portfolios doesn’t need to be complicated. To review three established strategies for reducing risk, visit our recent blog post on this topic. Be sure to talk to your clients about the goals of rebalancing—whether it is to improve performance, reduce risk, or both. And you’ll want to set the expectation that regular rebalancing is part of your investment management process. When portfolios are well diversified and periodically rebalanced, they should be able to weather market turbulence.

This material is for educational purposes only and is not intended to provide specific advice.

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