ETF Portfolio Reblancing

What is Portfolio Rebalancing?

It may sound contradictory for a buy-and-hold investor to engage in rebalancing and reallocating. But especially in a passive strategy, this corrective measure is important. Active investors often let the market determine the weighting of their portfolio and usually don’t rebalance consciously or frequently.

Rebalancing helps you maintain your risk level

As a long-term investor, it’s important to stick to your personal risk tolerance and maintain the risk level you originally defined in your asset allocation. This is where rebalancing comes into play as a corrective measure.

Example: If your asset allocation aims for 40% of your portfolio to be in low-risk assets, but your riskier assets perform well and grow in value, the proportion of your low-risk assets decreases. This results in an overall increase in your portfolio’s risk.

Increase returns with rebalancing: mean reversion

One key argument for rebalancing as a passive investor is the market’s tendency to return to its long-term (return) average—known as mean reversion.

• According to this theory, assets that have performed exceptionally well are likely to perform below average in the future, while underperforming assets are expected to recover.

Intuitively, most people tend to hold onto stocks that are rising in value—we don’t like letting go of “winners.” But theory clearly suggests: asset classes that have outperformed will slow down, and those that have lagged behind will catch up. So by rebalancing, you’re actually doing something beneficial for your long-term returns.

When is the Right Time for Rebalancing?

It it recommended checking your portfolio for rebalancing once a year. It’s best to set a fixed date in your calendar—perhaps at the beginning or end of the year—and take the time to do it then.

However, rebalancing only really makes sense if your allocation has deviated by 5% or more from your original target.

Example calculation: Is rebalancing necessary?

In this example, we’ll demonstrate how price developments can impact the ratio between risk-free and risk-bearing assets in your portfolio.

We assume a starting portfolio value of €10,000 with the following asset allocation:

• 30% risk-free portion (e.g., in a savings account) = €3,000
• 70% risk-bearing portion (e.g., global equity ETF) = €7,000

Explanation

• Scenario A: the risk-bearing portion gains value, increasing its share to 72.7%. Our take: there’s no need to rebalance just yet.
• Scenario B: the original asset allocation of 30% risk-free and 70% risk-bearing has shifted significantly and now stands at 20% vs. 80%. This scenario could happen if stocks perform exceptionally well in one year. A rebalancing is required.
• Scenario C: the risk-bearing investment performs poorly, there is also a significant discrepancy from the original asset allocation. This scenario might occur during crises—for example, during the “Corona Crash” in spring 2020. The share of your risk-bearing investments needs to be increased.

Asset allocation in a global portfolio

The same principle applies when rebalancing between equity ETFs within your stock portfolio.

Example:

If you’re managing a classic global portfolio with an allocation of 70% MSCI World and 30% Emerging Markets, and the MSCI Emerging Markets performs significantly better, rebalancing makes sense in order to restore the asset allocation of 70% to 30%.

In this case, you can restore the balance by pausing the savings plan for the MSCI EM, so the MSCI World portion will automatically become larger. Alternatively, if you’re not using any savings plans, you can achieve this by selling a portion of your MSCI EM shares.

Rebalancing in Practice

Rebalancing via savings plan

If you’re investing in ETFs and stocks through a savings plan, you can use it effectively for portfolio rebalancing.

This can be done by

👍 Advantage: In most cases, there are NO additional costs 👏.

👎 Limitation: When the size of your portfolio is already large, but your savings plans have a relatively small savings rate. In such cases, it is often more efficient to buy or sell shares directly.

Rebalancing through partial sales and purchases

When dealing with larger amounts or if you’re not investing through savings plans, you have the following option: You can sell (part of) your shares and buy new ones to balance your portfolio.

• Selling part of your ETFs that have performed above average to reduce the risky portion of the overall portfolio.
• Increase the shares of those that have not performed as strongly by purchasing more.

Costs of Rebalancing

If possible, you should rebalance via a savings plan, as this incurs no additional costs and allows you to keep your full return.

In the exceptions discussed above, where rebalancing requires partial sales and purchases, the following costs apply:

• Transaction fees for each order
• Taxes on your gains from partial sales

You should also consider the cost factor when deciding whether rebalancing is necessary. For tax reasons, it might sometimes make sense to rebalance through purchases instead of sales, as you will not pay taxes on a gain initially and can allow the money to work for you for a longer period.

Reference

• ETF Portfolio Rebalancing erklärt!