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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.
Since both of these funds are highly tax efficient, you might want to hold them in a taxable account. However, if cash has a higher utility for you in the taxable accounts than in the tax-deferred accounts, there is a potential conflict: My preference for tax efficiency indicates the fund should be purchased in the taxable account while my cash holding preferences indicate the funds for the purchase should come from the tax-deferred account. I can solve the conflict by assigning a level of importance to each rule (i.e., making tax efficiency more important than the cash location preference). With iRebal, these rules can be customized to reflect the individual methodology of each firm.
You can program iRebal to address such complexities as how often to rebalance, how tax consequences and trading costs affect the rebalancing decision, which account to sell from and which to buy to if you have a taxable account and a tax-deferred account and you want to change your asset mix.
But while iRebal's rules can be complex, they are transparent. This was an important distinction for Cameron Sheehan, operations manager of the security group at advisory consulting firm Moss Adams in Seattle, who recently purchased iRebal. "iRebal's rules are extremely transparent, which fits in with our compliance culture," Sheehan says. "You can almost build your Investment Policy Statement into your rules."
iRebal's ability to generate trades efficiently is what appeals most to Ken Solow, chief investment officer at Pinnacle Advisory Group in Columbia, Md. "We are tactical asset allocaters, so we use iRebal as a trade creation tool," he says. "We've done a tremendous amount of trading lately, and the program has performed flawlessly."
If there's a downside to iRebal, it's the $50,000 pricetag, which puts the program beyond the means of smaller firms--those managing less than $250 million. And iRebal doesn't offer instant gratification. Each firm must create its own custom rules, which means installation will take time. Also, unlike some rivals, iRebal isn't an online solution; you buy the software and, if necessary, hardware to run it. But iRebal is the only rules-based product on the market today that can totally automate location-optimization rebalancing and order-generation in a cost effective manner. This can allow advisers to capture additional risk-free returns. And if iRebal allows you to "save" the salary of one portfolio manager, the value proposition is compelling.
Tamarac Advisor 5.0
With prices reportedly starting in the $10,000 range, Tamarac Advisor 5.0 is often cited as a less expensive alternative to iRebal. According to the firm's website, the product "is a robust, web-based, global rebalancing and trade order generation system that provides customized, tax efficient rebalancing across an unlimited number of accounts or families." At first blush, it sounds very similar to iRebal, but on closer examination, the products are quite different.
Tamarac CEO Richard Thomas was kind enough to demo the latest version of the tool for me. Unfortunately, I wasn't provided a test account in order to navigate the program on my own; as a result, my observations are based primarily on the demo and input from advisers who use it.
Tamarac Advisor 5.0 has some nifty features. It excels at optimizing portfolios of individual securities and/or ETFs (the program can look through the ETF to the securities within it).
Steve Shnaper of The Danforth Group has been using Tamarac for about six months. "When we make a decision to buy one security and sell another, Tamarac helps us optimize the portfolio," he says. "It also helps us flag constraints we may have established for the portfolio, such as sector weightings. The program can also look at the cash balance and calculate the number of shares to buy."
Mark Scheffler, founder of the Appleton Group in Appleton, Wis., is also a fan. "We offer separately managed accounts and mutual funds that invest primarily in ETFs," he says. "We use Tamarac as a tool to manage risk, to manage portfolios of ETFs to a model and to generate trades."
Tamarac lets advisers rebalance a portfolio of mutual funds at the asset-class level. You can create minimum/maximum ranges for each class, and tell the program to rebalance only when an asset class moves outside the bands. The user would rank every security in the class for desirability, and the program would buy the highest-ranked security.
If you only use a few models with deferred accounts, this methodology might be acceptable. But, if each client has a unique portfolio mix, it can be problematic because the security rankings will change over time and differ across clients. Plus, you would probably need one ranking for taxable accounts and another for tax-deferred accounts. The firm claims it will add the ability to create separate rankings soon.
Therefore, when it comes to rebalancing portfolios of mutual funds, some advisers question Tamarac's utility. Balasa Dinverno & Foltz in Itasca, Ill., has used Tamarac to optimize portfolios for five years, says Principal and Co-President Mark Balasa. But that didn't stop his firm from buying iRebal for rebalancing. "When we invested in iRebal, we weren't aware that Tamarac was going to release a rebalancing product, but it would not have mattered if we did," he says. "I can't understand how you can rebalance using an optimizer. Any optimizer is a black box."
Not knowing what drives the decisions in an optimizer raises objections from other planners. "Our firm considered Tamarac, but we preferred a rule-based system," Solow says. Mike Leonetti, CEO of Leonetti and Associates in Buffalo Grove, Ill., agrees. "Tamarac works well when managing portfolios of individual securities, particularly when you are managing to a model, but for pooled products such as mutual funds, we find iRebal's rules-based approach appealing."
Using an optimizer instead of a rules-based system raises two concerns. Optimizers use proprietary models. If their underlying assumptions are incorrect, the output will be incorrect. Another problem is optimizer constraints. A portfolio built at the asset-class level using an unconstrained optimizer is often inconsistent with a diversified portfolio that an adviser would recommend to a client. If an optimizer recommends a large allocation that makes advisers uncomfortable, they can apply constraint, but if they constrain an optimizer too much, they are in essence dictating the output.
Tamarac Advisor is particularly well suited to advisers managing portfolios of individual stocks to a model, but it isn't as appropriate for those managing customized blends of mutual funds selected by asset class and managed at the household level. If transparency is an issue, Tamarac is not an ideal choice. We don't view it as a direct rival to iRebal, but rather as a separate class of software product.
eAllocator
If you can't afford $50,000 for iRebal, and Tamarac doesn't appeal to your process or your budget, eAllocator is another option. This server-based program is so new that only three firms are using it, but it is modestly priced at $5,000. Developed by Joel Javer, a principal at Sharkey, Howes and Javer in Denver, the program doesn't automate the rebalancing process, but rather facilitates manually rebalancing.
With eAllocator, the financial adviser sets a rebalancing schedule for each account at the outset. Say you decide to review portfolios with higher expected standard deviations monthly and those with lower expected standard deviations quarterly. You can program those schedules at the account level. You enter the program at the To Do screen, which lists the accounts, the last review date, the scheduled review date, the balance and the model associated with the account. Select an account and click "view" to see a summary of the holdings, the target by class, and the difference in percentage and dollar terms. A modest percentage difference is highlighted in yellow; a substantial difference is shown in red.
If a client is overweighed in U.S. large caps, you can drill down into the class to display every stock, its purchase date, tax basis and gain or loss. If you sell a holding, click on it to prepopulate the list of proposed trades with the appropriate symbol, then select an action (sell) and a dollar amount. As the trades are entered, the program updates the asset allocation, so you can see the impact immediately.
eAllocator offers some of iRebal's framework, but a human, instead of a computer, is the rules-based engine. The program will remind financial advisers when to review an account and identify asset classes that deviate from the model, but after that, it's up to the adviser to decide what, if anything, to sell or buy. As a result, eAllocator is good for firms that rebalance on a calendar basis, want to rebalance manually--but as painlessly as possible--and have relatively few accounts.
The program has two flaws. You can view accounts at the household level, but you can only execute trade orders at the individual level. Javer says eAllocator is adding the ability to create trades at the household level. You also can't view the status at individual tax lots. You just get an average tax basis for the entire holding.
eAllocator offers a more modest set of tools that either iRebal or Tamarac. It won't automate rebalancing and trade generation, but it will help manual rebalancers to be more efficient.
Low market returns combined with Gobind Daryanani's research are raising financial advisers' consciousness about rebalancing. There are big differences in approach, pricing and capability for the three products available that claim to help advisers rebalance.
Those who primarily invest in mutual funds and want to capture the excess returns implied by Daryanani's research would be best served by purchasing iRebal, if they can afford it. Those who want to pursue a similar approach manually will find eAllocator most useful. Tamarac could be used for rebalancing portfolios of mutual funds, but it appears better suited for advisers who want to optimize a portfolio of individual securities.
Joel Bruckenstein is a technology consultant to advisers and publisher of Virtual Office News, a practice management and technology newsletter. He can be reached at joel.bruckenstein@gmail.com.
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