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 portfolio to target the original allocation. We call the difference between the target allocation and the actual weights in the current portfolio (e.g. the actual allocation) 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 occurs when cash flows into or out of the portfolio are happening anyway. Every cash flow (deposit, dividend reinvestment or withdrawal) is used to rebalance your client’s portfolio. Fractional shares allow us to allocate these cash flows with precision to the penny.
Inflows: Your clients are rebalanced whenever they make a deposit, including when they auto-deposit or receive dividends in their accounts. We use the inflow to buy the asset classes that are currently underweight, reducing portfolio 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 your client’s portfolio drift is higher than normal (approximately 2% or higher), we calculate the deposit required to reduce the drift to zero, and make it easy for you or your client 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 your client 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 the 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 triggered whenever the portfolio drift reaches or exceeds 3%. Our algorithms check 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 selects the lowest tax impact lots, but stops before selling any lots that would realize short-term capital gains. Since short-term capital gains are taxed at a higher rate than long-term capital gains, we can achieve a higher after-tax outcome by simply waiting to rebalance until those lots become long-term, 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 will let you know how much to deposit, as described above.
Please note that the drift threshold is 5% for portfolios that contain mutual funds.
Allocation Change Rebalancing
Changing your client’s target allocation by moving the allocation slider and confirming the change will also cause a rebalance. Because you have chosen a new target allocation, Betterment will rebalance to the new target with 0% drift. This sells securities and could possibly trigger capital gains. Moreover, if you change the allocation even by 1%, your client will be rebalanced entirely to match your new desired target allocation, regardless of tax consequences. As with all sell trades, we will utilize our tax minimization algorithm to help reduce the tax impact. Additionally, before you confirm your allocation change we will let you know the potential tax impact of the change with Tax Impact Preview.
If you’d like to turn off 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 Advisor Support. Our team will be happy to help you do this.
This article was published on April 21, 2020Leave a comment (0)