Brown Brothers Harriman (BBH) considers manager selection to be the primary driver of long-term investment returns. That being said, taxable investors are inevitably faced with asset allocation and portfolio construction decisions that have the potential to add or detract from the compounding of their capital.

An important aspect of these decisions relates to the rebalancing of portfolios back to decided on asset allocation targets. What follows is an exploration of best practices for rebalancing as well as a discussion of the trade-offs that should be considered to help clients make well-informed decisions when rebalancing an investment portfolio.

Asset Allocation and Rebalancing

Before we discuss BBH’s philosophy on portfolio rebalancing, it is helpful to review our framework for asset allocation. At BBH, we work to establish a target asset allocation that balances a client’s desire for return with his ability and willingness to accept risk.

At its core, asset allocation is an exercise in balance sheet management. Just like companies, individuals and families have assets and liabilities. Family liabilities might include future tuition payments or the desire to retire at a certain age, engage in philanthropy, or leave wealth to future generations. Setting the appropriate asset allocation is both an art and a science, and each client’s portfolio is developed to ensure that her unique circumstances, objectives, and financial goals are appropriately reflected by the balance of equity and fixed income securities in the resulting portfolio.

In this context, we think about rebalancing as primarily an exercise in risk control – that is, one that keeps a client’s portfolio characteristics in line with the target asset allocation that has carefully been developed. Rebalancing is especially important for clients that have chosen a portfolio that includes a fixed income allocation.

For example, if a client desires high returns, has no risk constraints, and does not have an aversion to large drawdowns, he could simply invest 100% in equities, and the frequency and volume of rebalancing would be much lower. In this case, rebalancing would be constrained to occasional realignment of equity sub-asset class weights (for example, domestic vs. international equities).

Because most investors have a lower risk tolerance, they will have a diversified portfolio with a blend of higher-returning equity-oriented investments and lower-returning fixed income-oriented investments. These portfolio weights will drift based on the relative performance of the various asset classes, and as a result, the portfolio will gradually take on materially different risk characteristics over time. Rebalancing is the process that minimizes risk relative to the target allocation that the client has specified.

Taxes and Rebalancing

Of course, no discussion of rebalancing is complete without considering the impact of realizing capital gains and paying taxes. The realization of gains disrupts the long-term compounding of capital; however, even though taxes are a known cost, the peak-to-trough drawdown of a portfolio during periods of stress can prove to be far larger than the known tax hit from rebalancing.

Take the example of an investor with a $10 million portfolio composed of $6 million of equity and $4 million of fixed income. If this investor’s target allocation is 50% equity and 50% fixed income, then he should sell $1 million of equity and buy fixed income with the after-tax proceeds. If the realized gains amounted to 50% of the sale proceeds, the rebalancing would create a tax bill of $119,000.² The portfolio would now be rebalanced back close to its 50/50 target but would total $9.9 million instead of $10 million.

Consider what might happen in a drawdown scenario, though, where equities decline 30%, and fixed income increases 5%. In this case, the rebalanced portfolio would decline to $8.6 million, whereas the original 60/40 portfolio would decline to $8.4 million, a difference of $246,000. Furthermore, after the drawdown, the market would have moved the 60/40 equity/fixed income portfolio to 50/50, but the portfolio that was rebalanced prior to the drawdown would now be 40/60 equity/fixed income, or 10% underweight to equities. The “rebalanced” portfolio would be able to sell fixed income (with minimal tax impact) and buy equities (arguably at discounted prices) to return its asset allocation to its target of 50/50.

While scenarios like this tend to happen only a few times in a market cycle, the benefits of rebalancing in such instances are clear. The contrarian nature of rebalancing can at times be beneficial to portfolios – both when selling equities and subsequently repurchasing them – and in certain instances, this benefit can prove to be greater than the upfront tax cost. BBH believes that, unless client circumstances, including future family liabilities and risk tolerances, have changed, rebalancing is an exercise that should be undertaken.

Tax Deferral vs. Tax Realization

While rebalancing requires selling securities and paying taxes, investors should be careful not to assume that they can avoid taxes forever simply by not rebalancing. Taxes will be realized over time by both turnover within each manager’s portfolio and from client withdrawals.

Even managers that run extremely long-term-oriented portfolios will realize taxes, and sometimes taxable mergers and acquisitions remove the tax realization decision from the hands of the managers. It is therefore shortsighted to allow a portfolio to take on unintended risks in an attempt to avoid taxes. Importantly, delaying a rebalancing decision is not advisable, as declines in the value of the investment can quickly erase any slight advantage gained from delaying the realization of gains.

To further this point, one study analyzed a threshold-based rebalancing strategy from 1990 to 2004, quantifying both the rebalancing benefits as well as the cost in terms of forgone opportunities to defer taxes (and to allow the portfolio to continue compounding).³ The study found that this tax deferral penalty from rebalancing amounted to only 5 basis points (bps) over the 14-year period vs. a rebalancing benefit (that is, increased portfolio returns) of 55 bps.

The exact cost/benefit analysis from rebalancing will depend on the specific time period in question, but it is worth noting that rebalancing adds the most benefit to portfolios in volatile environments where there are many market fluctuations. Rebalancing also reduces portfolio volatility (including drawdowns) in a more reliable way in addition to the benefits of keeping the portfolio on target with its asset allocation.

Conclusion

While rebalancing is an important tool in our asset allocation strategy, there are trade-offs that need to be considered, and unfortunately, there is no one-size-fits-all solution. A number of factors, such as the expectation of large inflows or outflows, philanthropic plans, and the presence of both liquid and illiquid securities, can lead to different rebalancing strategies for investors that hold similar portfolios.

In addition, investors must regularly revisit their IPS to ensure it adequately reflects their current circumstances, as this will materially affect when and by how much they rebalance. BBH will continue to work with our clients to identify their unique situations and develop rebalancing strategies that make sense.

If you have questions about our approach to rebalancing portfolios, please reach out to a BBH relationship manager or a member of our Investment Research Group.