To make profitable software for the advisory community, you need a good story, research to back it up and someone to spread the word. Case in point: Harry Markowitz's research on the efficient frontier had been available since the 1950s, but it wasn't until the Brinson, Hood, Beebower study of 1986 that modern portfolio theory really became gospel in the planning community. Once it did, there was lots of money to be made selling optimization software.

Today's parallel may be rebalancing software. Like MPT, rebalancing has been around for years, but it is suddenly creating a new level of interest, driven partly by a low return environment. The man spreading the word about the benefits of rebalancing is Gobind Daryanani, a CFP, PhD and president of iRebal--also the name of his new software program. Whether its ilk will be the killer app that optimizers were in the 1990s is yet to be seen, but planners should know what rebalancing programs now on the market can do.

There has always been a case for rebalancing to reduce risk. You determine, say, that a $1 million portfolio of 50% stocks and 50% Treasury bills will meet your client's goals and risk parameters. If, after a year, the market is up 25%, the portfolio will have $625,000 in equities and $525,000 in cash, so the planner would sell $50,000 in stock and buy $50,000 in T-bills to restore the 50/50 ratio. The goal is not to increase returns--although that could happen in a down market--but to limit exposure to the riskier asset class (equities).

There is also a more recent, market-driven argument for rebalancing: the search for alpha. In the late 1990s, all you had to do was "buy the market" to make lots of money. From 1996 to 1999, the Vanguard 500 Index returned 22.9%, 33.2%, 28.6% and 21.1%, respectively. In this climate, there was little incentive to seek extra alpha from intelligent rebalancing. Plus, clients hated rebalancing because it meant selling their winners to buy asset classes that performed less spectacularly.

However, the turn of the century has brought on a much more tepid investing climate that could continue for years. The 50 basis points that didn't matter when portfolios were up over 20% a year can make a significant difference now that portfolios might deliver less than 5%. The question: Can rebalancing a portfolio add alpha? Daryanani's research suggests it can.

Among his findings is that rebalancing can add 30 basis points a year based on "location optimization," that is, managing several accounts at the household level and carefully considering where each asset is held within a family unit's accounts. He has also shown that rebalancing opportunistically (when an asset class moves out of a band, as opposed to on a calendar basis) can add 55 basis points more. Plus, Daryanani believes that tax-efficient rebalancing at the tax-lot level can add 10 basis points, and tax-loss harvesting can add another 10 to 20 basis points, although he has not yet confirmed these numbers through research. In total, rebalancing the Daryanani way could add 85 to 115 basis points of excess risk-free return. While this extra return is risk free, it's not totally free; the cost is the considerable time and labor required to rebalance manually.

Daryanani knows of what he speaks. He actually performed detailed manual rebalancing at RegentAtlantic Capital in Chatham, N.J., a firm that manages more than $1 billion in assets. He estimates that it takes a skilled individual, on average, 18 minutes per household, or three households per hour, to rebalance manually the typical RegentAtlantic household. That's some 20 to 25 rebalances per day. If RegentAtlantic had only 100 household relationships, and the firm wanted to check opportunistically for rebalancing opportunities across all households each day, it would need at least four full-time staff people to do so.

With the backing of RegentAtlantic and a few other firms, Daryanani set about developing a software program that could help an adviser complete this 18-minute process in a minute or two. The result is iRebal.

iRebal

iRebal automates the rebalancing process, including generating trade orders--and proposed trades can be reviewed manually before they are uploaded to a custodial system for execution. The program offers rebalancing at the household level across multiple accounts, both taxable and tax-free. It allows for multiple targets at the asset class, subasset class and individual fund level. The program can track individual tax lots and individual tax rates, as well as tax-loss carry-forwards. It can also manage intelligent tax location.

iRebal is an "expert" or rules-based system. It starts from the premise that advisers follow certain rules to rebalance a portfolio. Say you want to rebalance opportunistically, and your target allocation for a household is 10% of assets in U.S. small-cap stocks. You might not rebalance if the allocation drops to 9.7%, but you would if it dropped to 8%. As long as you can explain it and create a rule for it, the software can be programmed to do it. Another example: If you need to buy small-cap stocks, your default choice might be ABC Fund, which has a $50,000 minimum ticket amount. You can create a rule that redirects the purchase to HIJ Fund instead whenever the indicated small-cap price is less than $50,000.