Is now the time to rebalance?

By Giulio Renzi-Ricci, Head of Asset Allocation, Vanguard Investment Strategy Group

• Heightened market volatility can accelerate portfolio drift, meaning clients’ investments may not be in-line with their risk preferences and goals.
• There are a number of ways advisers can implement effective rebalancing, but none hold a distinct advantage over the other.
• Advisers can help maximise rebalancing efficiency with a few considerations before redressing the mix of equities and bonds.

With global equity and bond markets experiencing significant volatility this year, advisers may find client portfolios have drifted further than they usually would from their target allocation. Whether or not it is time to rebalance will depend on the strategy you have set with your client.

There are a number of rebalancing rules advisers can implement, but before we examine the different strategies, it’s important to note that the primary function of portfolio rebalancing is to keep client investments aligned with their tolerance for risk – not to maximise returns.

Vanguard believes that asset allocation, which considers a client’s risk tolerance, time horizon and financial goals, is the most important decision in the portfolio construction process. Research has found asset allocation to be the most important factor in determining long-term investment success¹, but without proactively rebalancing, portfolio allocations drift from their intended target as the returns of its assets diverge, leading to much higher portfolio risk.

For example, a portfolio with 60% equities and 40% fixed income at the end of 2003, if never rebalanced, would have had 80% in equities at the end of 2021, as shown in the chart below. In contrast, an identical portfolio that is rebalanced at the end of each quarter maintains the intended allocation and the preferred risk profile.

Changes in stock exposure for a 60/40 rebalanced portfolio and a "drifting portfolio"

Past performance is not a reliable indicator of future results
Sources: Vanguard, using data from Bloomberg. Notes: Daily returns data from 1 January 2003 to 10 February 2022. The initial allocation for both portfolios is 42% US stocks, 18% international stocks, and 40% US bonds. The rebalanced portfolio is returned to this allocation at the start of each quarter. Returns for the US stock allocation are based on the Dow Jones US Total Stock Market Index until April 2005 and on the MSCI US Broad Market Index thereafter. Returns for the international stock allocation are based on the MSCI All Country World Index ex USA and returns for the bond allocation are based on the Bloomberg US Aggregate Bond Index. All returns calculated in USD.

Rebalancing options for advisers

The rebalanced portfolio in the chart above uses a simple time-only rebalancing strategy, but other approaches are available to advisers. A time-only strategy will rebalance on a given date, regardless of the relative performance of the portfolio’s component assets. In a threshold-only strategy, rebalancing is triggered when a portfolio’s asset allocation has drifted by a given amount, say by five percentage points, irrespective of how often this happens – and it may happen a lot when markets get choppy.

A strategy combining the two will monitor the portfolio on a given schedule and have pre-set thresholds, but rebalancing will only occur when the two trigger-points cross. Here’s a simple breakdown of three common approaches to rebalancing:

• Time only: rebalancing on a set schedule, such as daily, monthly, quarterly, or annually.
• Threshold only: rebalancing when a target asset allocation deviates by a predetermined amount, such as 1, 5, or 10 percentage points.
• Time and threshold: rebalancing on a set schedule, but only if a target asset allocation deviates by a predetermined amount, such as 1, 5, or 10 percentage points.

What’s the optimal rebalancing strategy for clients?

Vanguard research has found that none of the major rebalancing approaches holds a distinct or enduring advantage over the others.² The responsibility is ultimately on advisers to identify the most appropriate approach for clients and apply it in a consistent and disciplined manner to give them the best chance of reaching their long-term financial goals. There are certain actions and considerations that Vanguard recommends to maximise rebalancing efficiency, including:

• Rebalancing with portfolio cash flows. Cash inflows, such as lump-sum investments, dividends and interest, should be directed into underweighted asset classes. Cash outflows, such as withdrawals from the portfolio, should start with overweighted asset classes.
• Being mindful of costs. Rebalancing only partially towards your target allocation can limit transaction costs. However, if the portfolio has drifted a lot, a partial rebalance may still leave the portfolio with a substantially different risk profile than targeted.
• Focus on tax-advantaged accounts. By rebalancing within tax-advantaged accounts (such as an ISA) first, advisers can reduce the tax burden of rebalancing across the client’s entire portfolio.

Vanguard’s multi-asset funds and model portfolios are regularly rebalanced by our in-house investment teams in a disciplined and cost-effective way that is appropriate for each strategy, giving advisers more time back to focus on other value-add tasks.

¹ G. P. Brinson, L. R. Hood, and G. L. Beebower, 1995. "Determinants of portfolio performance." Financial Analysts Journal 51(1):133–8. (Feature Articles, 1985–1994.)

² Source: Vanguard calculations, based on data from FactSet. For further information, see Zilbering. Y., C.M. Jaconetti, and F.M. Kinniry. “Best practices for portfolio rebalancing”, Vanguard Research, November 2015. Notes: Comparison of average annualised returns for time-only (at monthly, quarterly, and annual frequencies), threshold-only (after 1%, 5%, and 10% drift), and threshold-and-time (combining time and threshold frequencies) rebalancing strategies on a hypothetical portfolio consisting of 50% global equities and 50% global bonds between 1926 and 2014. No new contributions or withdrawals. Dividend payments were reinvested in equities and interest payments reinvested in bonds. Excluding costs. Global equities were defined as the Standard & Poor’s 90 from 1926 until 3 March 1957; the S&P 500 Index from 4 March 1957 until 31 December 1969; the MSCI World Index from 1 January 1970 until 31 December 1987; the MSCI All Country World Index from 1 January 1988 until 31 May 1994; and the MSCI AC World IMI Index from 1 June 1994 until 31 December 2014. Global bonds were defined as the S&P High Grade Corporate Index from January 1926 until 31 December 1968; the Citigroup High Grade Index from 1 January 1969 until 31 December 1972; the Lehman Long-Term AA Corporate Index from 1 January 1973 until 31 December 1975; the Barclays U.S. Aggregate Bond Index from 1 January 1976 until 31 December 1989; and the Barclays Global Aggregate Bond Index (USD hedged) from 1 January 1990 until 31 December 2014.