How Portfolio Rebalancing Works to Manage Risk for Your Clients
Portfolio rebalancing, when done effectively, can help manage risk and keep your clients on track to pursue the expected returns desired to meet their goals.
What is rebalancing?
Over time, the value of individual ETFs in a diversified portfolio moves up and down, drifting away from the target weights that help achieve proper diversification. Over the long term, stocks generally rise faster than bonds, so the stock portion of your client's portfolio will likely go up relative to the bond portion—except when you rebalance the client’s portfolio to target the original allocation. The difference between the target allocation for your client's portfolio and the actual weights in your client's current portfolio (e.g. their actual allocation) is called portfolio drift.
Measuring Portfolio Drift
At Betterment, we define portfolio drift as the total deviation of each asset class (put in positive terms) from its target allocation weight, divided by two. Here’s a simplified example, with only four assets:
|Total ÷ 2||10%|
A high drift may expose your client to more (or less) risk than you intended when you set the target allocation, and much of that risk may be uncompensated—meaning that the portfolio isn’t targeting higher expected returns by taking on the additional risk.
Taking actions to reduce this drift is called rebalancing, which Betterment automatically does for your client in several ways, depending on the circumstances, and always with an eye on tax efficiency.
Cash Flow Rebalancing
This method involves either buying or selling, but not both, and generally occurs when cash flows into or out of the portfolio are happening anyway. Cash flows (deposit, dividend reinvestment or withdrawal) can be used to rebalance your client's portfolio. Fractional shares allow us to allocate these cash flows with precision to the penny.
Inflows: Your client may be rebalanced if they make a deposit, including when they auto-deposit or receive dividends in their account. We use the inflow to buy the asset classes your clients are currently under-weight, reducing their drift. The result is that the need to sell in order to rebalance is reduced (and with sufficient inflows, eliminated completely). No sales means no capital gains, which means no taxes will be owed.
This method is so desirable that we’ve built it directly into our application. Whenever client drift is higher than normal (generally 2% or higher), we calculate the deposit required to reduce the client's drift to zero, and make it easy for them to make the deposit.
Although we show the deposit amount needed to bring drift back to 0%, smaller deposits also help reduce drift. In fact, the first dollars deposited have the largest impact on reducing drift. This means, for example, that depositing half the amount recommended to reduce drift to 0% will generally reduce drift by more than half.
Portfolio Drift vs. Deposit Size
The chart above is a hypothetical, illustrative example of the relationship between portfolio drift and deposits needed to rebalance without selling any assets. The blue line in the chart demonstrates the general relationship between deposit size and drift. As you can see, the first dollars of a deposit reduce drift by more than the last dollars. The dotted grey line shows what a linear relationship between drift and deposits would look like.
Withdrawals (and other outflows) are likewise used to rebalance, by first selling asset classes that are overweight. (Once that is achieved, we sell all asset classes equally to keep you in balance.) We employ a sophisticated ‘lot selection’ algorithm called TaxMin within asset classes to minimize the tax impact as much as possible in taxable accounts.
In the absence of cash flows, we rebalance by selling and buying, reshuffling assets that are already in the portfolio. When cash flows are not sufficient to keep your client's portfolio’s drift within a certain tolerance, we sell just enough of the overweight asset classes, and use the proceeds to buy into the underweight asset classes to reduce the drift to zero.
Sell/Buy rebalancing is generally triggered whenever the portfolio drift reaches or exceeds 3%. Once an account balance is at or past the minimum threshold, our algorithms check your client's drift approximately once per day. Our algorithms check your client's drift approximately once per day, and rebalance if necessary.
Note: In addition to the higher threshold, we built in another restriction into the rebalancing algorithm for taxable accounts. As with any sell trade, our tax minimization algorithm seeks to select the lowest tax impact lots, and stops before selling any lots that would realize short-term capital gains when possible. Since short-term capital gains are taxed at a higher rate than long-term capital gains, we can achieve higher after-tax outcomes by simply waiting for those lots to become long-term before rebalancing, if it's still necessary at that point.
As a result, it’s possible for your client's portfolio to stay above the 3% drift if we have no long-term lots to sell. Almost always, it’s because the account is less than a year old. In this case, we recommend rebalancing via a deposit to avoid taxes. The Portfolio tab of a client’s goal will show your client know how much to deposit, as described above, to rebalance via cash flow.
Please note that for advised clients on our Betterment For Advisors platform, the drift threshold is 5% for portfolios that contain mutual funds. For custom model portfolios, advisors can set a custom drift threshold.
Allocation Change Rebalancing
Changing your client's target allocation by moving the allocation slider and confirming the change could also cause a rebalance. Because you have chosen a new target allocation, Betterment will give you the option to select one of our three tax-aware migration strategies. Depending on which option you select, this could result in selling securities and could possibly realize capital gains. As with all sell trades, we will utilize our tax minimization algorithm to help reduce the tax impact. Additionally, before your client confirms the allocation change, we will let them know the potential tax impact of the change with Tax Impact Preview.
If you’d like to turn off your client's automated rebalancing so that Betterment only rebalances your client's portfolio in response to cash flows (i.e., deposits, withdrawals, or dividend reinvestments) and not by reshuffling assets already in the portfolio, please contact our support team at firstname.lastname@example.org.