Modern-day “rebalancing systems” are complex decisioning systems that automate customization, tax management and compliance.
The term “rebalancing” suggests an activity that is fundamentally conservative — returning portfolios to a semi-permanent ideal state. It reflects a static view of portfolio management that was probably never very accurate. Today, it’s not even close. Modern “rebalancers” are smart decisioning systems that take multiple inputs and produce trades that balance multiple competing goals. Rebalancers control risk, ensure compliance, generate tax alpha, manage transitions and implement customization.
The aim of modern rebalancers is not to return portfolios to a fixed stasis. We think of our own system as a “translation layer” whose purpose is to actively and quickly convert the intellectual capital of the firm into specific trades for each account in a way that adheres, every day, to each account’s customization and tax management preferences. Or, viewed the other way around, the aim is to convert each account’s customization and tax management preferences into specific trades that reflect the firm’s investment guidance.
What does this mean in practice? Someone wise once told me that the easiest way to understand any technology was to ask “what are the inputs” and “what are the outputs.”
Portfolio rebalancing systems: inputs
Let’s start with the inputs. Modern rebalancing systems take inputs from multiple sources, including:
The basics. This is the basic stuff you need to know before you can rebalance a portfolio. It includes:
- The holdings for each account, with tax basis
- Restricted securities
- Price data
- Corporate action data to ensure that corporate actions are synchronized across all data sources
- Risk model or other security substitution data to appropriately handle required substitutions in the case of never buys and counterbalancing underweights in the case of never sells
The intellectual capital of the firm. This is the output of the CIO and the firm’s investment policy committee. It includes the firm’s then current thinking on:
- Asset allocations and compliant limits on asset allocation customization for different risk profiles
- Recommended product and approved substitute products for each asset class
- Security models, e.g. a “our firm’s proprietary 50 stock large cap core model” (optional)
Client customization parameters. This is everything an advisor or a client may want in order to make their investment portfolio suit their needs. It includes:
- Choice of asset allocation, as well as asset allocation and product selection customizations
- Social screen, security and sector restrictions
- Cash needs such as one-off and periodic withdrawals, required reserves, etc.
- Tax management information and preferences
Client tax management parameters. This is all the information an advisor needs to effectively tax manage their clients accounts, including:
- Tax budgets
- The client’s marginal tax rates
- Loss carryforwards and YTD realized gains and losses
- The account tax status (e.g. “401K”, “taxable”)
Portfolio rebalancing systems: outputs
Rebalancers have two outputs:
Trades. The first and obvious output of a rebalancing system is trades. All rebalancing systems produce trades of one sort or another. Traditional systems may do as little as calculate how to implement model weights in each account, e.g. “to get the Smith account to 2% IBM, buy 520 shares”. For almost all forms of customization or tax management, these suggestions are just the starting point of generating actual trades.
Modern rebalancing systems do much more. Their trades are not a first pass at an answer; they are the complete answer. The output of a modern rebalancing system is actionable and compliant tax-lot level trades that ensure each account is faithful both to the intellectual capital of the firm and the customization preferences of each account.
Reports. The secondary output is reports. These include:
- Who/what/when: what trades were made, released by whom, when and why? And were portfolios that needed to be traded in fact traded in a timely manner?
- Proof of value added: reports that let advisors and firms document the value that they’ve added. How much did they save their clients through active tax management? Were all client request and customization parameters followed?
When you look at the above lists of inputs and outputs, it’s pretty clear that “rebalancing system” is a terrible name. They don’t “rebalance”. They customize and make portfolios tax-efficient; they make sure every account gets the benefit of the firm’s best thinking. They make it possible to automate that which was once manual, and through this automation make it possible to manage portfolios without compromise.
We really should call rebalancing systems something else. Decisioning systems? Implementation engines? We’re not sure. In all likelihood, folks will just keep calling them rebalancers. That’s OK. The name’s not important. What they do is. And it’s much, much more than rebalancing.