How should advisors approach rebalancing software that may seem like a black box?
The purpose of advanced rebalancing software (like ours) is to empower advisors, to remove constraints that force them to compromise between efficiency and service and to enable advisors to manage every portfolio as if it were their only portfolio. And it works. Our average user sees dispersion reduced by 60% while simultaneously creating more customized solutions and reducing taxes by almost 65%. Advanced rebalancers make it possible to efficiently review every portfolio every day, to offer every client a customized solution and to generate levels of tax alpha that exceed most advisors' fees. It’s tremendously valuable to both advisors and investors.
What’s not to love? Well, there’s the “black box” problem. Any rebalancing system sophisticated enough to automate tax, risk and expense management is going to be too complex for advisors to oversee every detail. There are just too many accounts, with too many tax lots, too many constraints and too many trade-offs for any advisor to anticipate every trade, every time. But the advisor — and not the software — is solely responsible for the portfolios. “I don’t know, the computer said I should do it” is not a great position for a fiduciary to be in. This causes advisors to wonder if they need to manually double check every trade generated by a rebalancer. They’re a fiduciary, after all. How can a fiduciary trust a “black box”?
So it would seem that advisors face a dilemma. Rebalancing software is so useful — so beneficial to investors — that it would almost seem a fiduciary obligation to use it broadly. But the advisor’s “the buck stops here” fiduciary responsibility would seem to push for very limited application. What is an advisor to do?
The question is a good one, and we thought we’d share how we and our clients answer it. The key insight is that the purpose of a rebalancer is to act as your agent, to enable you to have your ideas executed consistently across all the portfolios in your care. Think of a rebalancer as a super-assistant — or a whole department of assistants — dedicated to carrying out your commands. Most people view having assistants as empowering, not scary. And that’s the way to view technology like an advanced rebalancing system.
On a positive side, rebalancers, like assistants, extend your reach. On a negative side, rebalancers have a “black box” quality. But here’s the thing, from a manager’s perspective, assistants (employees in general) are also partial “black boxes.” This isn’t a critique, just a reflection of the reality that management can’t oversee every detail of what an employee did (and if they could, they probably wouldn’t need the employees in the first place).
The way advisors solve this “black box” problem when working with assistants is to set high-level guidelines, getting involved in the details only in cases that demand the advisor’s special attention, e.g. “out of bounds” customization requests or trades that affect accounts larger than $25mm.
This is the same approach our clients take with our rebalancing software. They give the rebalancing software “discretion” within carefully constructed bounds and apply oversight to the same sort of exceptional cases they might review with an assistant, e.g. accounts with trades:
- That would result in asset-class drift outside prescribed bounds
- Affected by delayed or faulty corporate action processing
- In accounts worth more than $25mm
- That would create turnover greater than 10%
- That would create taxes greater than 2.5% of portfolio value
Compared with an assistant, rebalancing software makes this type of review easy. More importantly, you can explicitly set parameters telling the system not to violate these bounds. Violating these commands is still possible, but only when two or more of these commands conflict with each other. For example, it’s common for our clients to set both asset-class drift constraints and tax budgets. When these conflict, the tax budget takes priority and a legacy portfolio can be left with out-of-bounds asset-class weights. It’s likely what’s desired, but possibly worth an advisor’s review.
“I can’t imagine managing money any other way”
Whether an advisor is dealing with software or an assistant, there’s an unavoidable trade-off between the level of manual review, on the one hand, and the level of efficiency and client care, on the other. Given an advisor’s limited time, the more stringent the review criteria, the fewer times each portfolio can be traded. And that means portfolios will miss out on opportunities for risk reduction, tax loss harvesting and closer adherence to the advisor’s asset allocation and product recommendations. The more an advisor can delegate, the more they and their clients benefit. This takes effort. Our experience is that advisors treat our system the way they would treat a new employee. They start out with somewhat tight review triggers, but relax them over time as they gain comfort and trust with the rebalancing system. They step in only where manual review adds the most value. Over time, the system becomes more valuable to both the advisor and their clients.
While it can take a bit of getting used to, most advisors like having assistants help them. And the same is true of tools like advanced rebalancing systems. Eventually, they wonder how they got along without them. As one of our user’s remarked, “I can’t imagine managing money any other way.”
For more on this topic, check out What is Rebalancing Automation?