The unprecedented market volatility that the Great Recession brought during the past two years has put tremendous pressure on financial advisors' back-office resources. One area of operations that has been particularly affected by volatility is advisory firms' ability to conduct securities trading.

To improve operations, advisors are turning increasingly to sophisticated rebalancing software, which can plot the most efficient rebalancing trades for a client's portfolio according to preset rules. According to Financial Planning's 2009 Software Survey, published last December, 33% of respondents said they were using rebalancing software, up from just 22% the previous year.

However, streamlined trading is not the only reason advisors are turning to the technology. Rebalancing software can add value to advisory firms by reducing trading errors, simplifying compliance and helping advisors meet their fiduciary obligation to conduct equitable trades for all clients.

TAKING NOTICE

Rebalancing client accounts across a firm's book of business is fraught with corner cases and unique circumstances. For example, a typical firm may define dozens of portfolio investment models and apply them according to client profiles based on objectives such as personal goals, risk tolerance and income requirements. Some clients may also own legacy positions in stocks with significant unrealized capital gains or sentimental value attached to them. Advisors may agree not to manage or liquidate the legacy positions, but they still account for the legacy stock when determining the asset allocation of the client's total portfolio.

These and other unique conditions cannot easily be managed by building spreadsheets, especially as a firm's assets under management grow.

One of the risks of using a spreadsheet is that the tool is vulnerable to simple mistakes. For example, spreadsheet formulas without the proper built-in ability to check errors can propagate calculation mistakes that may go unnoticed until long after trades are executed.

In addition, trade errors often occur when order instructions are entered manually into a custodian's trading interface. These errors include failing to specify dollar amounts instead of share quantities for mutual fund transactions, transposing characters in a ticker symbol or misplacing the decimal in a dollar amount field. These small errors can come with very big consequences, sometimes even causing the loss of a valuable client.

Rebalancing software is designed to minimize manual data entry as much as possible. Many of the popular rebalancing programs import client account data from portfolio accounting software and upload trade order files directly into custodians' trading systems.

While rebalancing rules can be configured by advisors (such as prohibiting the sale of securities with short-term holding periods), rebalancing formulas and calculations are embedded in the software and cannot be modified by users, thereby eliminating the potential for calculation errors.

MANY OPTIONS

When it comes to picking a software package, advisors have many choices. Tamarac's Tamarac Advisor was the leading rebalancing choice among the top five packages listed in Financial Planning's December report. Matt Stroh, vice president of marketing for the Seattle-based company, indicated that, between January 2007 and March 2010, the number of Tamarac clients grew from 74 to more than 325. During that same time period, assets managed by RIAs using Tamarac Advisor software ballooned from roughly $12 billion to more than $125 billion.

Rounding out the top five are ASI Portfolio Rebalancing Solution from Advisor Software; iRebal from TD Ameritrade; Total Rebalance Expert from TRX; and eAllocator, developed by the financial advisory firm Sharkey, Howes & Javer.

Ryan Callan, chief operating officer of La Jolla, Calif.-based Callan Capital, uses Total Rebalance Expert. TRX currently supports an interface with Schwab PortfolioCenter.

In an average year, Callan Capital effects approximately 7,000 trades for discretionary accounts, a number that increased roughly 15% to 20% during the heightened market volatility in 2008 and 2009. Three employees oversee the firm's trading and, according to Callan, the firm has not had a single trading error while using the software.

Erin Thomas Hynek, an investment analyst for O'Sullivan Creel Wealth Advisors based in Pensacola, Fla., uses the rebalancing solution from RedBlack Software in Bedford, N.H. Hynek also eliminated trading errors since adopting RedBlack in early 2009, he says.

STREAMLINING COMPLIANCE

But increasing trading efficiency is just one of the advantages of rebalancing software. Rule 204-2 of the Investment Advisers Act of 1940 outlines the books and records requirement for advisors, including the need to maintain a log of every purchase or sale of securities. Again, many advisors turn to spreadsheets to create a trade log, but manually updating spreadsheets with potentially thousands of trades is labor-intensive, to say the least.

As an alternative, nearly all rebalancing software utilities output a trade order file specifically formatted for compliance and recordkeeping purposes. The compliance trade order files can easily be aggregated to generate a record of all trades executed each year.

Some rebalancing solutions also include a trade order workflow feature that requires multiple users to review and approve pending trades. The order review can be used to alert the firm of an attempt, say, to purchase a "sin stock" for a client who wants socially conscious investments. At Callan's firm, up to three employees review order information before trade orders can be transmitted for execution.

FAIR AND EQUITABLE

Another benefit of rebalancing software is that the packages help RIAs with their fiduciary duty to maintain fair and equitable trading practices for all clients' assets.

Advisors who rebalance manually typically cannot complete all their desired transactions in one business day. To address this capacity constraint, Tim Simons, senior managing director of Ashland Compliance Group in Jacksonville, Ore., says most advisors try to trade accounts on a rotational basis, described on their Schedule F, Form ADV Part II, so that the same accounts aren't advantaged or disadvantaged. According to Simons, the rotation can be based on a variety of factors, including trading according to the primary advisor, the portfolio strategy or even alphabetically by account name. What's important is that the same rotational criterion is consistently used when conducting large trade orders to avoid favoring select clients.

The speed provided by rebalancing software makes it possible for advisors to implement portfolio trades fairly and equitably across all client accounts. Rebalancing software also dramatically increases a firm's trading capacity, even for the smallest advisory firms.

Glenn Meyer, founder of GDM Advisory Group in Jenkintown, Pa., manages approximately $285 million and rebalances with Tamarac Advisor. In 2009, GDM rebalanced all client accounts three times, with each event requiring between 4,000 and 4,500 individual trades, totaling well over 12,000 trades for the year. All of Meyer's rebalancing was completed with just one minor issue that was easily resolved in 24 hours. What's most impressive is that GDM has just two employees (including Meyer), and each rebalance took less than six hours to complete.

In addition, GDM's capacity to trade efficiently means no rotation criteria is required to ensure fair and equitable trading; all client accounts are processed on the same day. "If I tell [a client] that we're going to be rebalancing on January 25th, they see [that] on January 25th, everything was done," Meyer says.

It's clear through the growth of the rebalancing software market that advisors recognize the primary benefit of increased trading capacity provided by rebalancing tools. But even the lesser known benefits of enhanced compliance, liability reduction and fair trading practices for all clients offer compelling reasons for advisors to consider adding this tool to their practice.

Bill Winterberg, CFP, is a technology consultant to financial advisors in Dallas. His comments on technology and financial planning can be viewed on his blog at www.fppad.com.