We answer a question from a reader about rebalancing automation and transparency.
We recently hosted a webinar on the power of rebalancing automation to improve portfolio management. One of the viewers asked the following question, "How do you make it not sound like a black box? One thing advisors hate is not being able to walk through the thought process for making certain decisions”. We thought we’d share our answer.
(You can watch the webinar, with Greg Slater, CIO of Altium Wealth, and Bill Martin, CIO INTRUST Bank here. You can read a summary of one of the case studies we discussed here).
First, we think it’s a great question. Like other advanced rebalancing systems, the Smartleaf system uses optimization logic, which enables it to seamlessly make trade-offs between competing objectives, like low taxes vs. low dispersion. But optimization does not always lend itself to a simple walkthrough of the thought process. Hence the black box question. In practice, we see three approaches to dealing with the issue:
Approach 1. "Optimization within bounds"
Users set fences on the optimization that ensure that the portfolio conforms at a high level with investor expectations. However, within these fences, the optimization (the “black box”) is free to make trade-offs without worrying too much about whether individual trades are subject to simple explanations of the thought process.
The most common fences are boundaries on asset-class drift, e.g. “make sure that my equity/fixed income split is kept within 5% of target asset allocation”. This way comparisons of target vs. actual asset allocation always looks reasonable.
Approach 2. "A different transparency"
The antidote to a black box is transparency, and rebalancing automation systems greatly improve certain forms of transparency. They enable you to know, every day, that every portfolio is adhering to all constraints (security constraints, cash constraints, ESG constraints, drift constraints). They enable you to implement and describe a precise rebalancing workflow and approach to tax management. In short, rebalancing automation systems let you document that you have great control over drift, dispersion, constraints, taxes and compliance. This is a different, but arguably truer, form of transparency than “this is why I made this specific trade”.
Approach 3. "A different value proposition"
Firms that adopt rebalancing automation systems generally do not have product- or performance-oriented value propositions. They start with planning, and their higher aim is to act as the client’s financial coach. Conversations with clients are mostly not about trades, or even performance. They are about whether the client is on track to meet their goals, whether their portfolio has the right risk/return characteristics, etc. They care about expert tax management to increase after-tax returns. They care about being able to customize accounts with minimal risk. The specific rationale behind a given trade is largely moot. What matters is the value being provided to the client.
Herein lies the real answer to the question. Rebalancing automation enables firms to do more for their clients, and document the value they’re providing. In the end, this is the thought process that wins.