Updated Tuesday, July 29, 2014 as of 4:52 PM ET
More Flexible Approach to Rebalancing
Wednesday, May 7, 2014
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Portfolio rebalancing is designed to help clients buy low and sell high, the traditional recipe for investment success.

Bill Perry’s firm has melded academic research and decades of experience to develop a custom rebalancing process, facilitated by proprietary software. “We focus on risk,” says Perry, president of Park Place Capital Management in Milwaukee. “With an appropriate level of risk exposure, returns will come.”

Rebalancing might seem straightforward. If stocks are up and bonds are down relative to a client’s target asset allocation, stocks are trimmed and the proceeds go into bonds. If bonds are outpacing stocks, shift into reverse. Perry, though, frowns on what he terms “static rebalancing,” with standard rules on asset moves that trigger trades.

“We think rebalancing needs to take standard deviations into account, as well as an asset’s weight in the target allocation,” Perry says. “That will help you determine the ‘bandwidth’ for rebalancing, which has been called a ‘no-trade zone.’” Only when an allocation breaches the bandwidth is rebalancing carried out.

To illustrate, suppose a given asset class has a 25% target weight in a client’s portfolio. If that asset class has an expected standard deviation of 15%, that 15% is multiplied by a given number. “You can use any number,” Perry says, “but our experience has led us to favor a multiple of 2.” Thus, 15% is multiplied by 2 to get 30%, and that 30% is multiplied by the 25% target weight to get 7.5%.

As a result, the bandwidth is 7.5 percentage points, up or down. Here, the asset class’s target allocation is 25%, so the no-trade zone is a portfolio allocation between 17.5% and 32.5%. If the portfolio’s allocation to that asset class goes outside of those boundaries, the firm’s software issues an alert and a trade will be considered. “The way we set our bandwidth,” Perry says, “we don’t rebalance too often, and less frequent trading holds down transaction costs.”

What’s more, when rebalancing occurs, it goes only halfway to the target point, not all the way. In the above example, if that asset class went to 35% of the portfolio, it would be trimmed to 30%, not all the way down to the 25% target. “Again,” Perry says, “our experience has shown this works well.”

The smaller trim produces a smaller capital gain when winners are sold. In addition, the rebalancing is more acceptable to clients. They would still have a relatively large exposure to the amplified asset class, in soaring markets like the late-1990s dot-com surge, and they wouldn’t be buying as many out-of-favor assets in bleak times like the fall of 2008, when pundits were bemoaning the future of equities.

“We try to keep clients from selling low,” Perry says, “while also keeping them from staying in up markets to pick the last piece of fruit. Our mission is to help clients succeed over a long time horizon, and this approach to rebalancing has worked for us.”

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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