Home Adviser Fund Update Rebalancing Reconsidered Published February 10, 2017 Reassessing Rebalancing In our most recent Adviser Fund Update, we put two rebalancing strategies recommended by Vanguard and Fidelity—time-dependent and portfolio drift—to the test. Running through the data, we found that over nearly three decades, there was little difference in return between regular, periodic rebalancing, utilizing portfolio drift greater than 5% or 10%, and never rebalancing. For the details, please refer to our January 27, 2017 update. Readers sent feedback with questions on rebalancing’s role in riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. prevention as well as taxes, trading fees and other potential costs involved with the rebalancing strategies we analyzed. This week, we’ll take a look at these and other issues to consider in your approach to rebalancing. Controlling RiskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. Prominent advocates of rebalancing (including fund companies like Fidelity and Vanguard) often argue that it is a disciplined way to sell your winners high and buy market laggards on the cheap. By sticking to a defined allocation between stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates., risk-control rebalancers say, you can manage the overall risk or volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in. of your portfolio continuously through market cycles. Mathematically, this is absolutely true. A portfolio that is regularly rebalanced typically does exhibit lower volatility, resulting in a better risk-adjusted return over time, even if its total returns closely hew to or lag a never-rebalanced portfolio. What that risk control is worth to investors, especially when considering the costs, and the mechanical and emotional aspects we review below, is something that individuals need to determine for themselves. Our philosophy is to make strategic trades when opportunities present themselves rather than engage in regular or systematic trades (unless it’s something specifically requested by a client to meet their financial or investment needs). Trading Is Costly The strongest argument against becoming a rebalancing fanatic? Cost. When conducting our analysis two weeks ago, we assumed that every distribution was reinvested along the way, and did not factor in transaction fees or taxes on realized gains from trades—two critical issues when thinking about a rebalancing strategy. If you opt for annual rebalancing (or decide to do it even more frequently) in a taxable portfolio, carefully review how the various transactions you’ll make will impact your tax return on top of any fees you might incur. Ask yourself: Do funds in your portfolio have front- or back-end loads or short-term trading fees? Does the fund you’re buying make regular distributions? (Some funds pay annually; others quarterly or monthly.) Will selling your shares of a fund create a taxable gain? (This is obviously not an issue in tax-deferred accounts like IRAs and 401(k)s, but trading fees and loads should still be considered.) Thinking through these questions may help you realize that these hidden costs of rebalancing can quickly suck the wind out of your portfolio’s sails and be a drag on your returns. However, there are more ways to rebalance than simply buying and selling out of the funds in your portfolio on a fixed schedule or when allocations get out of whack. A simple idea is to consider redirecting distributions to or making new investments in the under-allocated funds in a portfolio. Or, if you’re at the point where you’re using the portfolio for income, you could sell more of your winners’ shares to reduce their allocation (this, of course, will create its own tax liabilityLiabilities are calculated by adding up your existing debts (mortgage, car loans, student loans, credit cards, etc.)., but you can’t avoid taxes forever if you’re drawing down your portfolio). These kinds of moves can be effective in keeping taxes and expenses down, at least when compared to making numerous trades over the course of a year. Keeping Emotions in Check You’re only human. Don’t overlook that when considering rebalancing. It’s easy to calmly discuss rebalancing a hypothetical portfolio, but in reality, many investors may find the idea tougher to act upon. It requires you to reward the losers in your portfolio with more money while reducing your exposure to proven winners. If you have a fund in your portfolio that’s been outperforming month after month, you’re probably not going to want to sell it to invest more in a fund that’s lost you money. But the standard theory of rebalancing requires that you do exactly that, and not just once, but over and over and over. As former Vanguard Chairman Jack Brennan put it: “If you are going to rebalance, you have to be absolutely clinical, or you are better off not doing it.” Of course, you could take the more relaxed approach and rarely rebalance—if at all—so long as you have a tolerance for the increased volatility that is part of an “unbalanced” portfolio. And when you consider the tax bill on frequent trades, you could come out substantially ahead. As illustrated by our analysis, from a returns standpoint, going with the flow isn’t that bad of an idea. Several additional things to consider: If you do choose to rebalance, either on a schedule or when your portfolio’s allocation moves past a predetermined threshold, is your target allocation still appropriate? Do you still have the same investment goals as when you started? Has your risk comfort zone changed? Over a decades-long period like the one we examined last time, your allocation may no longer be a good fit, requiring even more buying and selling. Are you prepared for the hassles and tax implications of making multiple trades per year? While many firms allow you to make trades online, you still open yourself up to having to review more paperwork, track every change to make sure there weren’t any errors (on your part or the fund company’s) and fill out extra lines on your tax return for every capital gain realized. This could add up to a lot of extra hassle, and it may be the biggest deterrent to tax-sensitive investors. If you’re following a portfolio-drift scheme, will you be able to stay on top of your portfolio and trade at the right times? As we showed last time, you could be in for both flurries of trades over a short period of time and years of sitting idle by following this strategy. Since there’s no routine, you’ll need to pay close attention—day in and day out—to execute at the right times. So is rebalancing necessary? Even though the media or your fund company may have you thinking so, when you look at the evidence, there is little benefit when it comes to the portfolio’s returns, and only some benefit when you think about risk. (Again, assuming no tax consequences or trading fees.) Of course, if rebalancing frequently gives you peace of mind and you’re willing to be clinical about it, your portfolio may not suffer too much for it either. Schwab Ups the Ante in Fee Wars Last week, Schwab fired another shot across Fidelity’s and Vanguard’s bows when it announced a plan to further reduce its index mutual fund’s fees to align with the fund company’s ETFA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. equivalents, as well as eliminate all investment minimums for these passive investment instruments. As part of the move, Schwab also cut its ETF trade commission to be more competitive with the two firms. Beginning March 1, 2017, Schwab’s market-cap-weighted index mutual funds—S&P 500 Index, Small-Cap Index and U.S. Aggregate BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. Index—will be available to investors at expense ratios a fraction of those offered for similar products at Fidelity and Vanguard. The reduction on Schwab S&P 500 Index will cut its expense ratio from 0.09% to 0.03%, while Schwab Small-Cap Index’s expenses will go from 0.17% to 0.06%. Schwab U.S. Aggregate Bond Index should become available to investors on February 23. Sources: Fidelity, Schwab, Vanguard. Note: Minimum Fidelity investment is $2,500 for Investor shares; $10,000 for Premium class of lower-cost shares. Minimum Vanguard investment $3,000 for Investor shares; $10,000 for Admiral class of lower-cost shares, and ETF shares have no minimums and the same expenses as the Admiral shares. While we at Adviser Investments firmly believe in the ability of top active managers to outperform the market—and our own expertise in finding these managers—we’re also happy to see any investor keep more of the money their investments earn. Index investors should cheer this move, and we’ll be watching closely to see if and how Fidelity and Vanguard respond to Schwab’s fee slash. About Adviser Investments Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trustsA legal document that functions as an instruction manual to how you want your money managed and spent in your later years as well as how your assets should be distributed after your death. Assets placed in a trust are generally safe from creditors and can be sold by the trustee in short order, avoiding the lengthy and costly probate process., institutions and foundations since 1994, and have more than 3,500 clients across the country and over $6 billion in assets under management. Our portfolios encompass actively managed funds, ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index., socially responsible investments and tactical asset allocation strategies, with particular expertise in Fidelity and Vanguard mutual funds. We take pride in being The Adviser You Can Talk To. Our minimum account size is $350,000. To see a full list of our awards and recognitions, click here, and for more information, please visit www.adviserinvestments.com or call 800-492-6868. This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. 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