Rebalancing Strategies

Section: Rebalancing Strategies Estimated study time: 45 minutes Content: Rebalancing is the process of restoring a portfolio to its target asset allocation after market movements have caused drift. Rebalancing serves two purposes: risk control (preventing the portfolio from becoming unacceptably overweight in recently appreciated, now potentially richer assets) and discipline (enforcing the buy-low-sell-high discipline by selling outperformers and buying underperformers). However, rebalancing has costs — transaction costs, market impact, and in taxable accounts, capital gains taxes — so the decision of when and how much to rebalance must balance these costs against the benefits of maintaining target allocation. The three primary rebalancing approaches are calendar rebalancing, percentage-of-portfolio (threshold) rebalancing, and range-based (corridor) rebalancing. Calendar rebalancing rebalances at fixed intervals (monthly, quarterly, annually) regardless of how much drift has occurred. It is simple to implement and predictable, but may rebalance unnecessarily when drift is minimal (wasting transaction costs) or fail to catch significant drift between review dates. Percentage-of-portfolio rebalancing triggers rebalancing when an asset class weight drifts beyond a specified tolerance band (e.g., ±5% from target). This approach is more responsive to actual market movements and avoids unnecessary transactions when drift is small. The corridor width — the tolerance band around each asset class target — is the key design decision. Optimal corridor width depends on: transaction costs (higher costs → wider corridors to reduce rebalancing frequency); asset class volatility (higher volatility → wider corridors, because high-volatility assets drift faster and would trigger constant rebalancing under narrow corridors); and correlation with other portfolio assets (higher correlation → narrower corridors may suffice for risk control). The standard guidance: corridor width is approximately proportional to the product of transaction costs and volatility.…