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1 Page 1 of 5 URL for this article: Develop Business/Managed Money Before You Rebalance Key Issues and Strategies By Wendi Webb horsesmouth Senior Editor October 31, :00 am ET OK, so you're sold on the benefits of rebalancing. Now what? Here's how to buff up on procedures before you call clients in for a year-end workout. Editor's note: This is the second of a two-part series on rebalancing clients' portfolios. For the first, which outlines 10 benefits of rebalancing, click here. On the surface, asset allocation seems to be a passive investment style. You establish a diversified mix of asset classes weighted to the client's risk-reward profile. Theoretically, the mix can last forever, riding out market cataclysms and bubbles. Revisions are infrequent, motivated only by changes in the client's longterm objectives. However, a very active ingredient rebalancing drives a good asset allocation program. And it's in the rebalancing process that an advisor earns his fees and gains clients' long-term trust. "Clients want leadership," says Thomas Quinlin, CIMA. "In 1999, investors thought they could throw a dart and earn money. Now the issue is to make sure that they don't get bumped out of the game." In a bad market, preserving clients' capital and retaining assets is a top priority. Rebalancing offers a number of strategic benefits to clients, as well as some business-building opportunities for you. The key is to have a well-developed protocol in place that shows discipline, expertise, and due diligence. Judicious rebalancing can be a win-win on both sides of the relationship. Related Articles A Case Study in Portfolio Rebalancing Our expert allocator explores the optimal rebalancing frequency in a conventional portfolio. Part III of a three-part series. How Often Should You Rebalance? While rebalancing frequently would seem to yield higher returns, the benefits depend on the asset classes involved. Part II of a three-part series. Rebalancing defined Technically, rebalancing means pulling the portfolio back to the strategic asset allocation stipulated in the Investment Policy Statement (IPS). Over time, volatility, account contributions, and asset class returns can cause the mix of stocks, bonds, and cash to drift from its target allocation. The Bonus in Rebalancing Clients' Portfolios Our expert asset allocator derives a formula for calculating the "rebalancing bonus" for assets with high volatility and a

2 Page 2 of 5 For example, a portfolio that is supposed to be invested 55% in equities, 35% in fixed income, and 10% in cash may now be overweighted in bonds and underweighted in stocks due to recent market performance. Assuming the client still maintains his same expected rate of return, time horizon, risk tolerance, and asset class preferences, the portfolio should be rebalanced back to its initial 55/35/10 allocation to maintain its diversification. The tough part comes into play when you and your client actually sit down to make some rebalancing decisions. Clients don't want to pull out of their winners only to invest the profits in underperforming asset classes. It goes against the grain not to let the winners ride. "We forced clients to take money out in 2000," says Quinlin, "chief client apostle" for Lifestyle Design Group, a San Jose, Calif. independent. "They hated it, but I'm dedicated to rebalancing because it keeps the client disciplined." low correlation to the rest of the portfolio. Part 1 of a three-part series. The Benefits of Tactical Asset Allocation Many consultants shy away from tactical asset allocation, equating it with market timing. But as long-term trends and client circumstances change, tactical adjustments can help the consultant add value. Rebalancing strategies Buying and selling asset classes shouldn't be an ad hoc decision. As a fiduciary, you need to develop criteria for making investment decisions that are outlined in the investment policy statement (IPS). A documented rebalancing procedure protects you and your client from making emotional and subjective investments. A good rebalancing policy should specify when the rebalancing will take place, the specific investment vehicles to be used, the tools and tactics that are acceptable, and who is responsible for executing the rebalancing. It should also describe the criteria you will use to adjust the portfolio. There are a number of rebalancing methods to choose from. David Goerz, chief investment officer at mpower, groups the most common strategies into three categories, ranging from easiest to more sophisticated: 1. Calendar rebalancing. This strategy specifies a schedule either quarterly, semi-annually, or annually for reviewing the portfolio and rebalancing back to the targeted asset allocation, if necessary. Goerz sees no need for rebalancing more than once a quarter unless stocks and bonds diverge by 10% or more. 2. Range rebalancing. This is a common rebalancing strategy among advisors and institutional investors. A range or band is set above and below each asset class. Whenever the asset class moves beyond the range, the portfolio is rebalanced back to its target allocation. Goerz finds that an optimal range is 3% 5%, although other advisors may set larger bands depending on the asset class and the aggressiveness of the client. "During the construction of the IPS, I create parameters for re-allocation," says an independent Florida advisor. "For major asset classes like stocks and bonds, I go +/- 7% from the stated allocation. For sub-classes like small cap and large

3 Page 3 of 5 cap, I use a 3% range." 3. Threshold rebalancing. One of the more sophisticated approaches is to monitor various portfolio characteristics particularly return, volatility, and correlation to other asset classes. Once an asset class moves beyond its desired standard deviation, for example, the asset class and portfolio is rebalanced to reflect the desired volatility. "I backtest the IPS to show the standard deviation of each asset class," says Quinlin. "I also develop a risk profile to monitor downside deviation in accounts and in each composite (portfolio). If I get whacked by some percentage, I rebalance." Which rebalancing method works best? It doesn't really matter, as long as you choose a strategy and follow it consistently, concludes a study published in the October 2001 Journal of Financial Planning. Five different rebalancing strategies two calendar-based, two range-based, and one "never balanced" were tested on several multi-asset class portfolios with differing risk profiles. The never-rebalanced portfolio exhibited the worst return, the highest risk profile, and the lowest Sharpe ratio. The four other methods proved to be much more effective, although they produced similar results in terms of risk and return. "Once an advisor and client have made the decision to rebalance, it does not matter which strategy they adopt," writes Sin-Yi Tsai, vice president of West Hills Institutional, an investment advisory firm, and author of the study. "Rather, advisors should first look to investors' sensitivity to transaction frequency and taxes, and to their own programming and system limitations." Factors influencing rebalancing decisions Before you start moving assets around, consider these issues: 1. Taxes. Selling out of your performers can generate capital gains taxes that your client may not be prepared to pay. "Since I use separate account managers, I know what the tax implications are," says the Florida advisor. "If at the end of a quarter, too much of the gain is short term, I can look at the holdings and determine if we want to wait a year and reduce the tax by 50%. This takes more effort on my part, but I think my clients appreciate the care." Of course, you may want to harvest some tax losses to offset capital gains now or in the future. Selling losers and replacing them may generate tax losses you can carry forward while still maintaining the model allocation. One financial planner likens it to "buying years of future tax-efficient investing." 2. Expenses. Rebalancing too frequently can generate a large number of costly transactions, depending on the accounts and type of securities used. The FPA study found that transaction-sensitive clients do better with a ranged-based policy rather than a mandatory calendar-based schedule. A general rule of thumb is to rebalance only when the benefits outweigh the costs. 3. Market timing. Chasing performance can be tempting when you're rebalancing, but if tactical asset allocation isn't part of your strategy,

4 Page 4 of 5 it can wreck the asset allocation and mislead clients into thinking that breaking the rules is OK. "I see a lot of market timing going on, with a majority rebalancing to the fixed-income side or moving toward large value with a dividend income component," says Scott Passias, regional marketing director of Lincoln Financial Distributors. "They're 'shifting' to another asset class not rebalancing. It's a Band-Aid to calm clients' fears." 4. Diversification. Rebalancing works best when the portfolio's asset classes move in opposite directions. In the FPA study, portfolios consisting of 80% 98% equities showed little benefit from rebalancing. All equities tended to move in tandem even those in different asset classes. Rebalancing proved to be of more help when asset classes showed a low correlation to one another. A correlation matrix can help you determine the direction of different asset classes. "Look for a correlation that is less than.8 or better," says Passias. "Anything greater than.8 is too highly correlated." 5. Illiquid assets. Assets like private equity or real estate can present a challenge when you're rebalancing one asset class to another. In many instances, you will have to reallocate around the more illiquid assets, although you should still track their investment characteristics as often as you can get data. Quinlin, a big believer in timber and real estate, tracks volatility on illiquid assets quarterly and reviews accounts in depth every six months. On more liquid accounts, he tracks volatility monthly and reviews accounts in detail every quarter. 6. Dividends. You may want to direct dividend income to a liquid "swing account" instead of reinvesting it directly back into the stock or fund that generated the dividend. This cash will not only help your client cover unforeseen expenses; you can also use it to invest in underrepresented asset classes, instead of selling out of winners. 7. Asset classes. While you don't want to add additional asset classes into the portfolio during the rebalancing process, you may have to choose between various sub-classes. Some advisors are rebalancing in a style-conscious way moving away from core because of the overlap between growth and value, says Passias. Others are more concerned about risk. "Stay with the unpopular asset class, and you'll be with the cheap," says an independent advisor from Pittsburg, Penn. "Recently, a group of foundation and endowment managers ranked the S&P 500 at the very bottom of nine asset classes even below Japan as the most over-priced. The only thing that investors should worry about is how much any asset contributes to the risk of the portfolio as a whole." For further reading: "New Developments In Portfolio Rebalancing: Techniques and Applications," Mercer Investment Consulting, August 2002 "Overview of Portfolio Rebalancing," (PDF) presentation by Michael D. Smith, CFA, and research director of Hewitt Investment Group. March 2000 "Do It or Lose It The Benefits of Rebalancing," David Goerz, mpower Café, February 2002

5 Page 5 of 5 "Rebalance of Power," Craig Israelsen, Financial Planning Interactive, April 2002 FOR REGISTERED ADVISOR USE ONLY. This content is for the exclusive use of horsesmouth members. Its accuracy and completeness is not guaranteed, and it is subject to horsesmouth Terms & Conditions and all applicable laws. Copyright 2002 horsesmouth, LLC. All Rights Reserved.