An elaboration of "look frequently, trade less" motto

FWR Staff

21 January 2008

Looking for rebalancing opportunities more often can yield several benefits. Scanning investment portfolios for rebalancing opportunities more frequently than called for by traditional methods reduces risk and produces superior returns -- and it could mean that adjustments have to be made less often. That's according to Gobind Daryanani, head of rebalancing research and products at ThinkTech, a subsidiary of TDAmeritrade.

"By looking frequently and rebalancing only when needed, the average rebalancing benefits are shown to be more than double that with the more traditional annual rebalancing," Daryanani writes in this month's Journal of Financial Planning.

In effect the article is an elaboration of the "look frequently, trade less" mantra Daryanani promulgated as head of rebalancing software maker iRebal, which he sold to TD Ameritrade last year.

Just looking

Rebalancing confers two potential benefits, Daryanani writes in Opportunistic Rebalancing: A New Paradigm for Wealth Managers. First, it can reduce risk by keeping asset classes from straying too far from their target allocations. Second -- assuming that asset-class allocations eventually revert to their means -- it can increase returns by compelling investors to sell asset classes that have become overvalued and buy more asset classes that have become undervalued.

But rebalancing usually takes place at set intervals -- once a quarter or once a year -- and so portfolio managers often miss chances to enhance their clients' holdings.

"The dates chosen for rebalancing are arbitrary, and thus we cannot possibly expect to catch the juiciest buy-low, sell-high opportunities," writes Daryanani.

So the author suggests that investors or their advisors look for rebalancing opportunities -- particularly with a view to catching juicy transaction opportunities -- every two weeks or so but actually rebalance only when and if it's called for.

But Daryanani makes a further refinement of traditional rebalancing by using what he calls "range rebalancing to a tolerance band." Traditional rebalancing usually involves adjusting asset classes precisely back to their target benchmarks every three, six or twelve months. But under the tolerance-band approach, stray asset classes are rebalanced to within a set "tolerance band," not to a precise benchmark.

Suppose for example that an asset class is 20% of the portfolio and that it has a 10% rebalance band. This means it is rebalanced back to 20% only when it strays outside of a range of 18% to 22%. But if the rebalance band also has a 5% tolerance band, it's adequate to bring the asset to within a target range between 19% and 21%, not exactly to 20%. This tolerance band approach ultimately requires fewer trades to keep a portfolio balanced and so cuts down on the expense of rebalancing, according to Daryanani.

Drawing on a study of rebalance bands, tolerance bands, and "look intervals" in several rolling periods between 1992 and 2004, Daryanani finds that looking more frequently than traditional calls combined with a 20% rebalance band works best.

Looking too often -- say, daily -- can result in a profusion of small trades, but intervals of two weeks seem to hit the spot.

"The benefits of opportunistic rebalancing far outweigh the costs associated with trading, taxes, and looking," writes Daryanani.

Here's the whole article. The Journal of Financial Planning is published every month by the Financial Planning Association, a Denver-based industry association. -FWR

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