Brown Brothers Harriman (BBH) considers manager selection to be the primary driver of long-term 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 the asset allocation targets that have been established. 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 portfolios.
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 or her 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 his or her unique circumstances and objectives are appropriately reflected by the balance of equity and fixed income 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 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.
Practical Considerations in Rebalancing
Rebalancing is a multifaceted concept. Among other rebalancing decisions, investors can rebalance at the major asset class level (cash, fixed income, equity and real assets), the sub-asset class level or even the manager level. Additionally, investors can rebalance on a set calendar schedule or do so only when an asset class drifts by a predetermined level from its target.
Before stepping into the markets to rebalance a portfolio, investors should always consider if their situation has changed and whether their investment policy statement (IPS) reflects their current circumstances. It is not uncommon for a client’s risk tolerance to increase over time as her wealth compounds in excess of her spending needs. In these cases, a portfolio with a higher equity allocation may be appropriate, and the investor may be able to amend her IPS to specify her desire for a portfolio with a different target asset allocation. As an example, consider a client that has grown her assets from $10 million to $20 million in 10 years and, as a result, has an equity portfolio weight that has drifted above original targets. If this client has had only minimal increases in the amount of spending expected from her portfolio, then she may have an increased ability to accept risk, and it could be appropriate to consider changing the portfolio’s target asset allocation to include a higher equity target and not rebalance.