Calendar-based rebalancing is inefficient and bad for clients.
Calendar-based rebalancing is pretty normal for the wealth management industry, but its days are numbered for two reasons: it’s inefficient, and, worse, it's bad for clients.
What is Calendar-Based Rebalancing?
Calendar-based rebalancing is just what it sounds like — you rebalance on a periodic schedule, e.g. once a quarter. In these periodic rebalancings, the idea typically is that you completely reset each portfolio, making the holdings exactly match their target weights. In between these “full rebalances,” you may do some incremental rebalancing to support time-critical events, like a cash-out request.
But these incremental trades usually require manual intervention and are therefore generally kept to a minimum. When they’re done, the aim is to disturb the portfolio as little as possible. They are considered “exceptions” — deviations from the normal workflow.
Tax management and customization are, themselves, a form of exception that require additional, manual intervention, so, in general, with calendar-based rebalancing tax management and customization is also kept to a minimum.
Calendar-based rebalancing is a simple approach that goes way back, predating any modern rebalancing tools. It was invented not because it’s an intrinsically desirable approach, but as a mechanism for working around the technological limitations of the day.
Why Calendar-Based Rebalancing is Inefficient
Calendar-based rebalancing sounds simple, but it isn’t. The basic problem is that there are more “exceptions” than you might want. Not just cash-out events, but trade errors, overdrafts, suspended accounts, tax management, customization, etc. The process for handling every one of those exceptions is inefficient.
And the problem is getting worse because the standards of rebalancing are going up. Advisors face competitive pressure to offer customization, tax management and careful drift control, but the calendar-based rebalancing tools they’re working with weren’t designed for this purpose, so every bit of improvement requires additional manual intervention. This means a process that was always somewhat inefficient just keeps getting more inefficient as the demand on portfolio managers grows.
Why Calendar-Based Rebalancing is Bad For Clients
If calendar-based rebalancing is inefficient, it ought, as a redeeming quality, at least be good for clients. It isn’t. It results in high drift, poor tax management and low levels of customization.
The problem with trading, say, every quarter is that you end up trading both too frequently and not frequently enough. There can be circumstances where a portfolio can go six months without needing rebalancing. And there can be times when it would benefit from trading twice in a month.
The downside of rebalancing when it’s not really needed is straightforward: it can result in unnecessary transaction costs and taxes.
There are basically two upsides to rebalancing more often, when appropriate:
- Greater fidelity to the account’s target asset allocation and security recommendations as a result of:
- Implementing investment ideas (a change in stock rankings, new stock selection, tactical asset allocations, new managers, etc.).
- Correcting for drift (from market movements, security transfers, etc).
- Investing new cash and inbound security transfers.
- Selling a short-term overweight position the day it goes long term.
- Loss harvesting.
- Returning, after loss harvesting, to the primary position after the wash-sale period expires.
All of these interventions can be beneficial to investors. However, the whole point of calendar-based rebalancing is to keep these sorts of intra-period trades to a minimum, mainly because there’s no practical way to do it. So investors lose out.
A Better Way: Cost-Benefit Rebalancing
There’s a better way: cost-benefit rebalancing. You don’t rebalance portfolios by the clock. You rebalance each account when it is beneficial for the client to do so, based on a cost-benefit analysis of each trade.
It’s a very different way to approach things. Not surprisingly, it’s better for investors. It enables wealth managers to simultaneously lower return dispersion and provide investors with higher levels of customization and tax management. We can quantify this. Compared with calendar-based rebalancing, cost-benefit rebalancing reduces BOTH return dispersion and taxes by more than 60% (See Are Your Portfolios Noisy?). As a general rule, there’s a tradeoff between low taxes and low dispersion. That it’s possible to simultaneously reduce both is a measure of just how subpar traditional rebalancing is.
Cost-benefit rebalancing is also more efficient. Why? Because with a cost-benefit approach, rebalancing — even customized tax-optimized rebalancing — can be automated. The key is that, by its basic design, it can handle complex tradeoffs. The way cost-benefit rebalancing works is that competing objectives — getting a portfolio closer to its target asset allocation and security weights, reducing taxes and transaction costs, etc. — are combined into a single cost-benefit score. If the net score is high enough (or if trading is required to satisfy a mandate such as cash-out request), the account trades. Otherwise, it doesn’t.
And so your rebalancing becomes simple: every day you trade every account that has a high cost-benefit score (or that has mandated trades). It’s a simple, programmatic, daily rebalancing workflow. This not only makes it easy to handle cash flows, implement investment ideas, tax manage, etc. It also, almost as a side effect, makes it easy to deal with process failures like trade errors and suspensions, and this makes cost-benefit rebalancing less error prone. For example, you no longer need to have a special process to deal with accounts that are temporarily suspended — as soon as they’re unsuspended, the daily cost-benefit rebalancing workflow will step in, automatically.
Calendar-based rebalancing was invented as a mechanism for working around the technological limitations of the day. Those limitations no longer exist, and that’s raised the bar on competitive standards for rebalancing. Cost-benefit rebalancing is better for clients and more efficient. The days of calendar-based rebalancing are numbered.
For more on this topic, check out What is Rebalancing Automation?