Rebalancing

Rebalancing is the process of realigning the weightings of one's portfolio of assets. Rebalancing involves periodically buying or selling assets in your portfolio to maintain your original desired level of asset allocation. Although the investor may start with a given portfolio design, as time passes the portfolio will move away from the original asset allocation targets.

Why rebalance?
As time progresses, the performance of the asset classes in your portfolio will tend to move in different directions and your portfolio will drift from the original asset allocation. As part of portfolio maintenance, it is desirable to periodically readjust that allocation, in order to control the risk. Arnott and Lovell concluded that "Rebalancing has historically improved returns without increasing risk. Theoretically it can continue to do so." Bernstein has concluded that, in some circumstances, greater returns may be achieved by periodic rebalancing.

Nevertheless, the investor should regard rebalancing as primarily a procedure for controlling the risk, not boosting the return, since it is impossible to say in advance whether the returns will be greater or less.

When to rebalance?
This can be done on a calendar schedule, or if allocation thresholds in the investment policy statement are exceeded. Such rebalancing thresholds may be set on either an absolute basis - that is, as a percentage of the entire portfolio - or on a relative basis, as a percentage of the particular holding. For example, a statement that "Equity weightings to remain in the range 45% to 55%, with a nominal target of 50%" is a threshold of 5% absolute. An example of a relative threshold could be a statement that "Small Cap Stocks to be set at a weighting of 10%, with a deviation of not more than 25% relative" (which would be a 2.5% absolute threshold). A "5/25" rebalancing policy (that is, rebalancing when asset allocations drift more than 5% absolute or 25% relative from targets) has been advocated by Swedroe.

Strategies for rebalancing
Rebalancing can be most easily done in accumulation mode by adding new funds to that section of the portfolio that is most out of balance on the downside, or in withdrawal mode by selling a portion of that section of the portfolio that is most out of balance on the upside. In registered accounts, where there is no immediate tax liability, it is also often possible to switch funds from one component to another at reasonable cost. Rebalancing in a taxable portfolio, however, may incur significant tax, and should usually be avoided in that case.

To minimize costs, frequent rebalancing should be avoided. In registered accounts, yearly rebalancing may be a reasonable compromise between risks and costs.

Detailed example 1: complete rebalancing with index funds
Ed, whom we met in building a portfolio, has a  simple index portfolio with four index mutual funds. His target asset allocation is:
 * 50% Canadian bonds
 * 25% Canadian equities
 * 10% US equities
 * 15% International equities

Ed has a registered account and there are no tax consequences to rebalancing. Ed has a "5/25" policy but he hasn't looked at an investment statement for five years and he decides that a full rebalancing exercise is needed. He gathers the following current values from his account:
 * Canadian bonds (TD Canadian Bond Index – e): $5800
 * Canadian equities (TD Canadian Index – e): $4000
 * US equities (TD US Index – e): $1000
 * International equities (TD International Index – e): $2200
 * Total: $13000

The first step is to calculate the current allocation by dividing the dollar amounts for each fund by the total dollar amount:
 * Canadian bonds: 45%
 * Canadian equities: 31%
 * US equities: 8%
 * International equities: 17%
 * Total: 100%

Ed subtracts his current allocation from his target allocation and gets:
 * Canadian bonds: +5% (he needs 5% more)
 * Canadian equities: -6% (he has 6% too much)
 * US equities: +2%
 * International equities: -2%
 * Total: 0%

So Ed needs to buy 5% bonds (positive number) to get him to 50%, sell 6% Canadian equities (negative number) to get back to 25%, and so on. These percentages are reconverted to dollar amounts by multiplying them by the total account value of $13k:
 * Canadian bonds: +$700 (buy $700 worth of bonds)
 * Canadian equities: -$750 (sell $700 worth of stocks)
 * US equities: +$300
 * International equities: -$250
 * Total: $0

To keep things simple, Ed decides to sell $725 worth of the Canadian equity fund and buys bonds with that amount. He then sells $275 of the international equity fund to purchase some US equities. Close enough!

Detailed example 2: new contribution with ETFs
Marilla C. has a three ETF portfolio which sits entirely in a RRSP account at Discount brokerage. Her target asset allocation is:
 * 40% Canadian bonds
 * 30% Canadian equities
 * 30% Global equities

She’s just added $5000 of cash to her account, and there was already $143 sitting there from recent ETF distributions. She reviews her current ETF holdings:
 * VAB (Canadian bonds): $34 658
 * ZCN (Canadian stocks): $35 217
 * XAW (Global Stocks): $31 123

The total value of her account, including the cash, is $106 141. She divides the market value of each ETF by the account total to get her current allocation:


 * VAB (Canadian bonds): 32.7%
 * ZCN (Canadian stocks): 33.2%
 * XAW (Global Stocks): 29.3%
 * Cash: 4.8%
 * Total: 100%

Marilla subtracts her current allocation from her target allocation from and gets:
 * Canadian bonds: +7.3% (she needs 7.3% more)
 * Canadian equities: -3.2% (she has 3.2% too much)
 * Global equities: +0.7%
 * Cash: -4.8%

Marilla decides to buy more VAB (Canadian bonds) with all the cash available, $5143. This will not bring back Canadian bonds all the way to her target of 40% but will get her most of the way there in one transaction. The rest of the imbalances, for example the surplus of Canadian equities, can be addressed during her yearly rebalancing scheduled in a few months.

During market hours, she obtains a quote for VAB: the bid is $26.43 and the ask is $26.45. Marilla subtracts the $10 commission from her cash, which leaves $5133. Dividing this by the current ask price for VAB yields 194.1 shares. So she enters a limit order for 194 shares of VAB, using the ask price as her limit. This order is promptly executed and adds $5131.30 to her existing VAB holdings. Taking the commission into account, there is less than $2 of cash left in her account.

The current values and percentages are now:
 * VAB (Canadian bonds): $39 789.30 or 37.5%
 * ZCN (Canadian stocks): $35 217 or 33.2%
 * XAW (Global Stocks): $31 123 or 29.3%
 * Cash: $1.70 or 0.0%
 * Total: $106 131 or 100%

These calculations can be automated in a rebalancing spreadsheet to save time (see external links below for an example).