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Best practices for portfolio rebalancing - Vanguard

Vanguard research July 2010 best practices for portfolio rebalancingAuthorsColleen M. Jaconetti, CPA, CFP Francis M. Kinniry Jr., CFAYan ZilberingExecutive summary. The primary goal of a rebalancing strategy is to minimize risk relative to a target asset allocation, rather than to maximize returns. A portfolio s asset allocation is the major determinant of a portfolio s risk-and-return Yet, over time, asset classes produce different returns, so the portfolio s asset allocation changes. Therefore, to recapture the portfolio s original risk-and-return characteristics, the portfolio should be rebalanced. In theory, investors select a rebalancing strategy that weighs their willingness to assume risk against expected returns net of the cost of rebalancing . Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy.

Vanguard research July 2010 Best practices for portfolio rebalancing Authors Colleen M. Jaconetti, CPA, CFP® Francis M. Kinniry Jr., CFA Yan Zilbering

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Transcription of Best practices for portfolio rebalancing - Vanguard

1 Vanguard research July 2010 best practices for portfolio rebalancingAuthorsColleen M. Jaconetti, CPA, CFP Francis M. Kinniry Jr., CFAYan ZilberingExecutive summary. The primary goal of a rebalancing strategy is to minimize risk relative to a target asset allocation, rather than to maximize returns. A portfolio s asset allocation is the major determinant of a portfolio s risk-and-return Yet, over time, asset classes produce different returns, so the portfolio s asset allocation changes. Therefore, to recapture the portfolio s original risk-and-return characteristics, the portfolio should be rebalanced. In theory, investors select a rebalancing strategy that weighs their willingness to assume risk against expected returns net of the cost of rebalancing . Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy.

2 This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of 1 Assuming a well-diversified portfolio that engages in limited with Vanguard > > ( investors) Vanguard believes that the asset allocation decision which takes into account each investor s risk tolerance, time horizon, and financial goals is the most important decision in the portfolio -construction process. This is because asset allocation is the major determinant of risk and return for a given Over time, however, as a portfolio s investments produce different returns, the portfolio will likely drift from its target asset allocation, acquiring risk-and-return characteristics that may be inconsistent with an investor s goals and preferences. portfolio rebalancing is extremely important because it helps investors to maintain their target asset allocation.

3 By periodically rebalancing , investors can diminish the tendency for portfolio drift, and thus potentially reduce their exposure to risk relative to their target asset See Brinson, Hood, and Beebower (1986); Brinson, Singer, and Beebower (1991); Ibbotson and Kaplan (2000); and Davis, Kinniry, and Sheay (2007).2 Notes on risk: All investments are subject to risk. The performance data shown represent past performance, which is not a guarantee of future results. The performance of an index is not a representation of any particular investment, as you cannot invest directly in an index. Investment returns will fluctuate. Investments in bond funds and ETFs are subject to interest rate, credit, and inflation risk. ETF shares can be bought and sold only through a broker (who will charge a commission) and cannot be redeemed with the issuing fund. The market price of ETF shares may be more or less than net asset value.

4 rebalancing events and resulting costs (taxes, time, and labor) increase significantly. (For instance, monthly rebalancing with no threshold would require 1,008 rebalancing events, while annual rebalancing with a 10% threshold would require only 15 rebalancing events.) As a result, we conclude 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. Return data for Figures 1 through 8 and Appendixes A-1 and A-2 of this paper are based on the following stock and bond benchmarks, as applicable: Stocks are represented by the Standard & Poor s 90 from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Composite Index from January 1, 1975, through April 22, 2005; and the MSCI US Broad Market Index from April 23, 2005, through December 31, 2009.

5 Bonds are represented by the S&P High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Lehman Long-Term AA Corporate Index from 1973 through 1975; and the Barclays Capital Aggregate Bond Index from 1976 through part of the portfolio -construction process, it is important for investors to develop a rebalancing strategy that formally addresses how often, how far, and how much : that is, how frequently the portfolio should be monitored; how far an asset allocation can be allowed to deviate from its target before it is rebalanced; and whether periodic rebalancing should restore a portfolio to its target or to a close approximation of the target. While each of these decisions has an impact on a portfolio s risk-and-return characteristics, the differences in results among the strategies are not very significant.

6 Thus, the how often, how far, and how much are mostly questions of investor preference. The only clear advantage for any of these strategies, as far as maintaining a portfolio s risk-and-return characteristics, and without factoring in rebalancing costs, is that a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than a portfolio that is never paper s discussion begins with a review of the significant rebalancing opportunities into equities over the past 80 years. We then establish a theoretical framework for a rebalancing strategy, which is that investors should select a rebalancing strategy that balances their willingness to assume risk against expected returns net of the cost of rebalancing . In several scenarios, we explore the trade-off between various potential rebalancing decisions and a portfolio s risk-and-return charac-teristics.

7 Finally, we review practical rebalancing considerations, emphasizing rebalancing for risk control, not return maximization. 3 Costs of rebalancingThroughout this paper, the term costs of rebalancing refers to:s Taxes (if applicable): If rebalancing within taxable registrations, capital gains taxes may be due upon the sale if the asset sold has appreciated in Transaction costs to execute and process the trades: For individual securities and exchange-traded funds (ETFs), the costs are likely to include brokerage commissions and bid-ask spreads.* For mutual funds, costs may include purchase or redemption fees. s Time and labor costs to compute the rebalancing amount: These costs are incurred either by the investor directly or by a professional investment manager. The costs may include administrative costs and/or management fees, if a professional manager is in mind that in addition to these costs, there may be trading restrictions that could limit the frequency of transacting on the accounts.

8 Finally, since there is little difference in the results between the frequencies analyzed, these costs would suggest that less-frequent rebalancing ( , annually or semiannually, rather than daily) would be preferred. *The bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept for many investors, rebalancing can be difficult It is not uncommon following significant declines in the equity markets (as in the 37%-plus decline in the stock market in 2008) for investors to question the benefits of rebalancing . Although the magnitude of the recent decline was surprising, negative stock returns should not have been totally unexpected. In retrospect, the average annualized return of equities from 1926 through 2009 was ;3 however, the annual return of stocks during that period ranged from 54% to 43% (see also Figure 1), with a loss in approximately one out of every four years (25 of the 84 years had a negative return).

9 Understandably, during the recent market crisis, poor investment performance coupled with considerable uncertainty about the future made it seem counterintuitive for investors to rebalance their portfolios by selling their best -performing asset classes and committing more capital to underperforming asset classes. However, historically, significant rebalancing opportunities into equities have occurred after strongly negative market events. A look back at other historically significant rebalancing opportunities defined here as occurring when a hypothetical 60% stock/40% bond portfolio has deviated from its rebalancing threshold by at least 5 percentage points shows that investors who had a plan and maintained their target allocation by rebalancing during trying times in the markets have typically been rewarded over the long term. Since 1926, a rebalancing opportunity into equities has occurred on only seven occasions: 1930, 1931, 1937, 1974, 2000, 2002, and At each of these times, as shown in Figure 2, the trailing one-year returns were extremely poor, and the outlook for the equity markets was bleak.

10 Investors who did not rebalance their portfolios by increasing their allocation to equities at these difficult times may have not only missed out on the subsequent equity returns but also did not maintain the asset-class exposures of their target asset allocation. 3 Stocks are represented by the Standard & Poor s 90 from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Composite Index from January 1, 1975, through April 22, 2005; and the MSCI US Broad Market Index from April 23, 2005, through December 31, 2009. All returns are in nominal Assuming a 60% stock/40% bond portfolio and annual rebalancing with a threshold of 5%.4 Range of calendar-year returns for stocks: 1926 through 2009 Figure 35% or more1937 35% to 30%1974 30% to 25%20021930 25% to 20% 20% to 15%200120001973196619571941 15% to 10%1990196919621946194019321929 10% to 5%199419811977195319391934 5% to 0%19871984197019600% to 5%20072005199219781956194819475% to 10%200419931971196819651959192610% to 15%2006198819861982197219641952194919441 5% to 20%1999199819961983196719631951194220% to 25%20091989197919761961194325% to 30%2003199719911985198019551950193819363 0% to 35%199519751945192735% to 40%1958192840% to 45%193545% to 50%1954193350% to 55%10 5 Notes: All returns are in nominal dollars.


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