An important part of keeping your portfolio's asset allocation and risk exposure consistent is a periodic rebalancing between different types of index funds. Since market volatility can lead to riskier assets (i.e., stock funds) claiming oversized positions — and less-risky assets (i.e., bond funds) sliding in weightings — such movement within a portfolio can result in an inappropriate level of risk for your unique financial situation.

After all, you should've already taken our Risk Capacity Survey and discussed with your IFA wealth advisor just how much risk is really needed to reach your long-term financial goals. We've found that setting realistic expectations — and building a holistic financial plan — are key to building and maintaining wealth. 

Putting a Plan In-Place

After a thorough evaluation of risk capacity, let's say an investor settles on a globally diversified index portfolio of 60% equities and 40% fixed income. A year later, stocks have increased stock market performance, the equity portion of that portfolio could rise to 70%, which would leave the fixed income portion at 30% of total portfolio assets. By contrast, after a market decline you may discover that equities now comprise 50% of the portfolio's overall allocation, and fixed income has increased to 50%.

Over a longer period, such shifts in portfolio dynamics are even more pronounced. For example, research by Vanguard has estimated that a 60/40 portfolio — using off-the-shelf (i.e., commercial) stock and bond indexes from Dow Jones, MSCI and Bloomberg — never rebalanced from 1989 through 2021 would've wound up with 80% in equities. "Absent rebalancing, portfolio allocations will drift from their intended target as the returns of its assets diverge, leading to much higher portfolio risk," the paper's authors noted.¹

Such a study shows that shifts in asset allocation are to be expected over the life of a portfolio. Rebalancing back to the initial (i.e., target) allocation keeps the portfolio at a more consistent risk exposure. In either of the above examples, a set of rebalancing trades would correct the asset allocation back to 60% equities and 40% fixed income. 

The IFA Rebalancing Methodology

In general, rebalancing involves selling assets that have gone up and using those proceeds to buy assets that have gone down. Selling index funds that've performed well — and conversely buying more of the asset classes that've performed poorly — is often an emotionally difficult task for investors, as it seems counterintuitive and confusing.

The counterintuitive logic of rebalancing often leads investors to either do nothing — or even worse, to follow their fight or flight instincts and sell the past losers to buy more of the previous winners.

This goes completely against the prudent principle of rebalancing. A portfolio that is neglected or not rebalanced appropriately takes on a less than optimal risk-return trade-off. More to the point, the investor no longer has the confidence of knowing the expected return or the potential risks of their neglected portfolio, which are keys to prudent investing.

Keeping an appropriate asset allocation for a portfolio is important in order to reduce any natural inclination by investors to move in and out of markets as conditions change over the short-term. In their long-running research series looking at triggers for poor investment behavior, analysts at Dalbar Inc. point to these upheavals as a constant pull over time. Such an ongoing tug of emotions leads to the average U.S. investor's fund portfolio to underperform against a buy, hold and rebalance strategy. 

In situations where IFA's investment committee has decided to replace a mutual fund with an ETF in the portfolio's implementation, we'll replace it with the specified ETF. That might result in a client portfolio holding both an open-end mutual fund and ETF in the same asset class. 

Maximizing Tax Efficiencies

Since IFA utilizes both open-end mutual funds and ETFs for rebalancing, it's important for you to understand some of the other nuances involved in trading these two fund types.

For one, open-end mutual funds trade based on a closing net asset value (NAV) at the end of each trading day. Opportunities don't usually exist to trade a mutual fund during trading hours and the fund trades at its daily closing NAV. Conversely, an ETF trades similar to an equity stock in that it can be bought and sold at any point during market hours. As a result, an ETF can trade below (discount) to its NAV, at its NAV or above (premium) to its NAV throughout the trading day.

When the rebalancing process requires IFA's portfolio management team to sell an open-end mutual fund and use the proceeds to purchase an ETF, it will always execute the ETF purchase on the next trading day. This is done to eliminate a potential scenario where intra-day market volatility causes the amount of the ETF purchase to be greater than the amount of the proceeds derived from the sale of the open-end fund at the end of the trading day. This is commonly known as "double exposure."

By waiting until the next day to purchase the ETF, the risk of not having enough proceeds to cover the same-day purchase is removed. However, this process does introduce the possibility that the price paid to purchase the ETF on the next day will be higher than the previous day. Given that the price of the ETF at any given moment is a random event and impossible to predict, IFA focuses their processes on extinguishing the double exposure risk.

For instances in which an ETF is being sold with the intention of using the proceeds to purchase an open-end fund, both transactions will occur on the same trade date. This is possible due to the fact that IFA's traders will know the total value of the sale of the ETF prior to entering the order to purchase the open-end fund.

There is another important trading scenario that takes place during rebalancing. This happens when one open-end fund is being sold to purchase another open-end fund. In this circumstance, IFA's portfolio management department might liquidate the entire position in the first fund and buy a partial position in the second fund. The remainder of the second fund will be purchased at the closing NAV on the next trading day after the final amount of the liquidation is known. Projecting a partial buy amount is possible because the purchase is based on the NAV of that fund at the close of the trading day and not on an intra-day price. 

The IFA Rebalancing Process

The logic behind rebalancing is that it maintains a consistent level of risk exposure. Although rebalancing is necessary to maintain risk, it can incur transaction fees and taxes in taxable accounts. For this reason, rebalancing is a decision that should be handled with care.

IFA's rebalancing policy can be simply explained as follows: IFA utilizes highly sophisticated software to review all client accounts for potential rebalancing during the first part of February, May, August and November each year. Client portfolios are evaluated based on predetermined tolerance bands, trading costs and potential tax consequences.

Once an opportunity is identified, an email containing the details of the recommended rebalancing is sent to each client that has not opted for auto-rebalance. Upon receipt of approval from the client, IFA will process the rebalancing trades. For clients that have opted to sign-up for automatic rebalancing, the trades will be completed after the review.  This process can take approximately 30 days to complete for all clients. 

In summary, rebalancing is designed to keep an investor's risk exposure consistent over time and in-line with their capacity to hold risk.

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Footnote:

1.) Vanguard, "Rational Rebalancing: An Analytical Approach to Multiasset Portfolio Rebalancing Decisions and Insights," October, 2022. 

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. IFA utilizes standard deviation as a quantification of risk, see an explanation in the IFA glossary. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey to determine which portfolio captures the right mix of stock and bond funds best suited to you.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/