Rebalancing policy

Portfolio management does not stop when the portfolio is built. Prices move at different speeds, so the weights drift away from the targets on their own.

Left alone, the portfolio quietly becomes something else. The fast-rising assets grow their share, and those are usually the risky ones. The client ends up with more risk and less diversification than she agreed to.

So the Investment Policy Statement should contain a well-defined rebalancing policy, written before any drift happens.

The workbook says it has to address two things. First, how the target weights themselves will be adjusted when the client's needs, circumstances or risk appetite change. Second, the set of rules for restoring the original exposures when markets move.

And it has to weigh a trade-off. Rebalancing is not free, so the policy decides how much drift is worth paying to correct.

Why a written policy (Chapter 21, section 21.1). Two different things cause the need to rebalance, and the policy must cover both.

Market movement. Over time, security and asset weights drift from the desired levels. Prices of all assets do not change in the same proportion — high-return assets change faster than low-return assets, and high-return assets are typically also the high-risk ones. Left unrebalanced, the portfolio's risk exposure levels change, the portfolio may become more concentrated than desired, and the intended diversification is undermined.

Change in the investor. For individuals, a change in employment, marital status or the birth of a child may alter the investment goals and objectives, and the amount available to invest. Liquidity requirements may change too.

Hence the workbook's conclusion: it is desirable that the IPS contains a well-defined rebalancing policy addressing (1) the adjustments needed in the investor's target asset class weights to reflect changes in needs, circumstances and risk appetite, and (2) the set of rules that guide the process of restoring the portfolio's original exposures to various asset classes in times of changing capital market expectations.

The trade-off the policy must strike (section 21.2). While drafting a rebalancing policy, a trade-off has to be arrived at between the costs of rebalancing and its benefits. The benefit is stated precisely: rebalancing reduces the present value of the expected loss from not rebalancing, that is from deviating from the optimal strategic asset allocation.

The costs are three:

1. Monitoring and valuation — frequent review of the portfolio;
2. Execution — trading to restore the desired exposures, and different assets cost different amounts to trade. International equity costs more than domestic equity; illiquid assets such as private equity or direct real estate are more complicated to rebalance than listed equity;
3. Taxes — rebalancing typically sells the appreciated asset and buys the depreciated one, and the sale of an appreciated asset attracts a tax liability. The workbook counts that tax as a cost of rebalancing.

What the policy has to choose (section 21.3). A decision is needed on the periodicity of rebalancing and on the tolerance levels of drift. The two routes are time-based, or calendar, rebalancing — monthly, quarterly, half-yearly or annually, with quarterly a popular choice — and threshold-based rebalancing, where tolerable percentage deviations are stated.

The workbook attaches no figure to the policy itself — no required review frequency, no mandated tolerance band, no cost ceiling. The only numbers in the chapter belong to the threshold illustration in section 21.3.1, a 60% equity target with trigger points at 50% and 70%, and those are an example of what a policy might contain, not a rule the workbook imposes.

Illustrative figures. The rebalancing clause in an IPS for a Rs 2,00,00,000 portfolio:

A year on, markets have moved:

Equity is more than 5 points out, so the policy triggers. Restoring targets means holding Rs 1,31,40,000 of equity — a sale of Rs 13,60,000, with Rs 7,70,000 to debt and Rs 5,90,000 to gold.

Now the cost side the policy was written to weigh. The equity being sold has appreciated. At an effective capital gains cost of, say, 12.5% on a Rs 4,00,000 embedded gain in the parcel sold, the tax bill is Rs 50,000, plus roughly Rs 7,000 of brokerage and charges.

So the client pays about Rs 57,000, or 0.26% of the portfolio, to remove 6.2 points of unintended equity risk. The policy's job was to decide that question in advance, in the calm before the drift — not in the moment, when the temptation is to leave a winning position alone.

Chapter 21 (Portfolio Rebalancing), section 21.1 (Need for rebalancing), states the two issues a well-defined rebalancing policy in the IPS must address, and section 21.2 (Costs and difficulties of rebalancing) gives the cost-benefit trade-off, the three cost heads and the tax point.

Expect a question on what the rebalancing policy should address, on which document it belongs in (the IPS), on the three causes of rebalancing cost, and on the benefit as the workbook states it — reducing the present value of the expected loss from deviating from the strategic asset allocation. The tax-as-a-cost point is a favourite, because candidates treat tax as separate from transaction cost.

• The policy is written in advance and lives in the IPS. It is not a decision taken when the drift appears.
• Two triggers, not one. Market movement and a change in the investor's needs or circumstances. The second one changes the targets, not just the holdings.
• Tax is a cost of rebalancing. The workbook counts the capital gains liability on selling the appreciated asset as part of the cost side of the trade-off.
• Costs differ by asset class. International equity costs more to trade than domestic equity; private equity and direct real estate are harder still. A single tolerance band for every asset ignores that.
• The benefit is a reduction in the expected loss from drifting, not a higher return. Rebalancing is a risk-control action, and it takes no view on market direction.
• The policy is not the technique. Time-based and threshold-based rebalancing, and the corridor and its trigger points, are what a policy chooses between.