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How to Choose a Rebalancing System

Six questions that will help you select the right rebalancing system.

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This is a buying guide for wealth managers looking to select a new rebalancing system. The point is not to recommend specific systems, but to help you decide what type of rebalancer best fits your needs (we tackled this topic before, though with more focus on how rebalancers differ and less on how you choose the system that is best for you). What follows is a series of questions, with recommendations based on your answers.


1. Do your advisors talk about individual trades with clients? Do your clients see their advisors as market experts who can help them make better trading decisions?

For example, will you talk about why you bought Ford or why you sold IBM? Do you invite clients to participate in these decisions? This is a traditional role for advisors: the “advisor as expert.” Markets are complex and investors want someone who can help them make trading decisions that result in higher returns.


2. Do you want your advisors to trade and rebalance portfolios (in contrast to delegating rebalancing to a central group — or outsourcing entirely)?

If you answered “Yes” to either of the previous two questions, then you want an alert-based rebalancing system. It will alert you to trading opportunities, such as loss harvesting or drift correction, but leaves it to the advisor to choose what and when to trade.

Alert-based rebalancing systems are fairly basic, and they’re inexpensive. They are often bundled together with other portfolio management systems, such as trade order management and reporting.


3. Are you OK doing without customization or tax-management?

No one is against customization or tax management, but are they critical to your offering? If you’re OK doing without, then you should be OK with a basic rebalancer. Basic rebalancers are models-based systems that will generate the trades necessary to bring each portfolio back to its target model. They support the efficiency, scalable rebalancing of non-taxable non-customized accounts. Basic rebalancers, like alert-based rebalancers (the two functional capabilities are usually combined in one system), are inexpensive and often bundled with other systems.


4. Are traditional SMAs, where you outsource stock selection and trading to one or more asset-class specialists, central to your offering, and do you need to offer traditional SMAs at scale?

Separately managed accounts (SMAs) are basically “unwrapped” mutual funds, baskets of individual securities that are directly owned by the investor. SMAs, like mutual funds, are typically guided by specialists who focus on a particular asset class (e.g. US Large Cap Value).

In what we call a “traditional SMA”, the third-party specialist provides both stock selection AND trading services (the alternate version where they just provide models is discussed later). One way to implement traditional SMAs is by sending each specialist manager funds for each account. However, this approach doesn’t scale well and makes consolidated reporting difficult. A better solution to implement a traditional SMA is to create a “sub-account” (AKA a sleeve or partition) for each manager to control. With a sleeve-based system, the third-party manager doesn’t receive funds; they just get trading authority over a sleeve/sub-account.

If offering traditional SMAs (where you outsource both selection and trading) at scale is important to you, you’ll want a sleeve-based accounting and rebalancing system. These are basically shadow accounting systems, creating and maintaining virtual subaccounts that are reconciled back to the primary custodial account. But they all come with rebalancing modules that will help you rebalance between sleeves (i.e. take money from one manager and give it to another).


5. Is “sleeve-level” SMA performance reporting critical to your offering?

In contrast to traditional SMAs, with “models-based SMAs”, the third-party manager doesn’t do any trading. They just provide a model. In this setup, you no longer need to have a sleeve-level accounting system. This is really good, since sleeve-level accounting systems are expensive, and breaking the portfolio into separate sleeves makes it much harder to manage portfolios holistically, meaning that sleeve-based systems tend to result in both higher taxes and higher overall drift.

The one reason to keep a sleeve-based accounting system in a models-based world is if it is critical to your offering to provide clients with sleeve-level performance information. That is, if you are using XYZ’s large cap model, do you need to report the performance of the XYZ model in each account (as opposed to, say, reporting on the manager’s composite or reporting the due diligence info used to select managers)? If yes, it is useful to keep the XYZ holdings isolated in their own sleeve, which means you need a sleeve-based accounting and rebalancing system. If you don’t specifically need a sleeve-based system for generating sleeve-based reporting, they’re best avoided.


6. Is it critical that you be able to deliver customization and tax management at scale?

With the decline of performance-based value propositions, the importance of tax optimization and customization (such as ESG screens and risk-customization around outside holdings and labor income) increase.

At small size, firms can manage modest levels of customization and tax optimization by hand. With an optimizer, they can do better. But to deliver high levels of customization and tax management at scale, you need a holistic (post sleeve) system with automated implementation of customization and tax management. Like a basic rebalancer and like sleeve-based rebalancers, these systems are models-based and are best operated by a central group. But the holistic system can support unlimited customization and tax management.1



As you read through this, you may find that your firm doesn’t fall cleanly into any one category. If this is the case, what should you do? The best answer is to buy the system that best fits not where you are today, but where you want to go. That is, where do you think your firm ought to be in five years? Buy a system that will help you get there.

1 It’s often assumed that “models based” and “centralized” lead the cookie-cutter, non-customized, non-tax managed portfolios. This is incorrect. Done right, models-based, centralized implementations lead to more, much more, customization and tax management. The reason is that it can be automated, which makes customization and tax management free -- and when you make anything free, folks consume more of it.

President, Co-Founder