Periodic portfolio rebalancing is an accepted and recommended tool in modern financial planning. Its purpose, of course, is to maintain the allocation that an advisor and client determine to be optimal in reaching agreed-upon investment goals.
To be sure, the recent period of market volatility is likely to have skewed many allocations and prompted advisors to rebalance client portfolios — probably more frequently than they had planned. That, of course, raises the question of when and how often rebalancing should be done to optimize its effectiveness.
The answer to the “when” question is far from clear cut. Calculations by SPDR Americas Research found that rebalancing a standard 60/40 portfolio (a basic mix of U.S. and international equities plus aggregate bonds) produced cumulative returns ranging from 730% to 781% since 19901, all depending on whether the portfolio was rebalanced monthly, quarterly or annually. Annual rebalancing's were calculated for each of the year's 12 months.
The analysis found that there was no perfect rebalancing period that consistently optimized returns. It also found that the different rebalancing periods can create yearly return patterns that at times can differ by more than 8%.
Given that selecting a particular rebalancing period won't eliminate the randomness of returns, advisors can try to counterbalance the randomness. They can do this by creating overlapping portfolios that are rebalanced at different times; rebalancing portfolio components by fixed-percentage weights, such as equities not exceeding 65% of the rebalancing; or by selecting a period that strikes a balance between exposure management and costs.
Costs are an important consideration in rebalancing, especially if rebalancing is done more frequently. Ironically, advisors and clients whose portfolios consist largely of low-cost exchange traded funds, often overlook cost as a factor in rebalancing. ETF expense ratios are so low in comparison to other investment vehicles that many advisors and clients simply assume that the cost of rebalancing portfolios consisting of ETFs is inconsequential.
Expense ratios, however, do not measure an ETF's total cost of ownership, which includes the expense ratio as well as the cost of trading — a drag on performance that can actually be greater than the expense ratio. The cost of trading combines the cost of buying and selling the ETF itself as well as the cost of trading the securities that constitute the ETF, and enable it to track the performance of its index. Both costs are a function of liquidity.
Liquidity, which enables buyers and sellers to carry out their trading plans quickly and with little or no effect on price, results from the market presence and interaction of many buyers and sellers. A measure of liquidity, the bid-ask spread, is wide when few buyers and sellers are present or when there is a sizeable imbalance in buying and selling interest. Wide spreads result in higher trading costs, which become particularly important in the total cost of ETF ownership when the frequency of rebalancing increases. In fact, depending on rebalancing frequency, trading costs can significantly accumulate and have a larger impact on the total cost of ownership than any expense ratio difference between two ETFs.
Generally, widely held ETFs with high average daily trading volume are more liquid than less actively traded ETFs. Also as a rule, ETFs tracking broad market indexes tend to be more liquid than narrow, sector-based ETFs. This is true both in the secondary market, where many buyers and sellers are meeting due to the ETF's popularity, and in the primary market, where the securities that constitute broader indexes tend to be more actively traded and more liquid than the thinly traded securities that often constitute more-targeted ETFs. Periods of market volatility, in which buying and selling interest can be lopsided as well as prone to shifting swiftly, only tends to make any inherent illiquidity worse.
But even in narrower ETFs there can be significant cost differences that can dramatically affect the total cost of a strategy, even over the short run. For sector rotation strategies with a monthly rebalance, for example, a more liquid ETF with an expense ratio higher than a less liquid equivalent may be significantly more cost-effective after accounting for trading costs.
Advisors, therefore, must be mindful of rebalancing's costs even when its benefits — reducing portfolio risk and enforcing sell high, buy low discipline — are all the more evident during periods of market volatility. Opting for ETFs with lower trading costs in order to capitalize on the advantages of more frequent rebalancing may be something for advisors and their clients to consider during turbulent times.
1What 'Back to the Future' Can Teach Us About Portfolio Rebalancing, SPDR Blog, 04/02/2019.
Important Risk Discussion State Street Global Advisors and InvestmentNews are not affiliated. ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as “creation units.” Brokerage commissions and ETF expenses will reduce returns. State Street Global Advisors Funds Distributors LLC member FINRA SIPC Exp date 4/30/2020 2735937.1.1.AM.RTL
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