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Clear Thoughts
Portfolio Rebalancing
Originally Published Friday, March 4, 2005
| Portfolio rebalancing is the process of readjusting a portfolio to its original model. How do we rebalance our portfolios? What factors are important when rebalancing? |
We define "rebalancing" as a readjustment of the portfolio to its optimal model state. Stated plainly, we buy and sell amounts of each stock, new or existing to precisely match our model. Although we trade all month as defined by our investment policy, stock prices fluctuate every trading day. Rebalancing, which we employed in all of our portfolios this morning, could be performed daily, weekly, monthly, annually or any time frame. We have tested rigorously to find our optimal result.
As investment managers, we believe that one must never waiver when buying or selling stocks. We believe the stricter the discipline, the more consistent the results. However, there are potential tradeoffs in portfolio rebalancing. Are we gaining better returns, or are we simply causing a higher tax burden? Is there a right balance? Are we style drifting if we approach a tipping point that would trigger an automatic sale, based on our investment policy, or can we "ride the stock for weeks" until the threshold is crossed? How many days can a stock be rated #21 (or #26 in the Small Cap portfolios) without being sold? Certainly here at Clear Asset Management we have had to make numerous decisions and draw our lines in the sand. One of the more complex processes that we have in place is how we go about rebalancing our portfolios.
Rebalancing is a requirement for success in money management. After all, every investment portfolio in existence has a slightly different purpose or goal, and over time as stock prices fluctuate, it is possible for that purpose to be undermined. For example, let's look at the Clear Mid Cap Growth Portfolio, where companies must range in market capitalization between $1 billion and $8 billion. What should the manager do when a company has grown to the point where its value is now $8.04 billion? Though the portfolio has clearly benefited from its growth, it no longer fits the profile with which the portfolio was designed. In industry terms, this is called "style drift," and it challenges managers on a regular basis. When is the right time to make a decision on selling this investment and replacing it with the next best prospect?
Ultimately, the answer to this question requires guidelines and needs to be made simple so orderly execution can take place. This decision is not made in a vacuum. On the other side of avoiding style drift is the need to mitigate portfolio turnover. Turnover is an albatross for portfolio managers, because purchases and sales of assets can generate tax consequences and expenses from trading. Here at Clear Asset Management this is not a significant problem since we pay no commissions per trade with our broker, and all our taxable gains and losses are netted out against each other.
So we balance the need for strict adherence to style with the costs associated with turnover. In designing our portfolios, after exhaustively examining such issues, we concluded that a monthly rebalance is the best way to go.
This is because when one of our investors buys the Clear Mid Cap Growth Portfolio, we believe it is of paramount importance that he or she actually has mid cap growth stocks, and only mid cap growth stocks, as investments. Therefore, we practice strict adherence to our style, especially since we do not pay per-trade commissions.
We tested weekly and quarterly time frames, reviewed our inter-balancing buy and sell disciplines and looked at other relevant variables. We found that monthly rebalancing gives us sufficient responsiveness to fundamental and price data changes throughout our portfolios maximizing our hypothetical, and to date, live returns. Thus far, through this approach, we continue to beat benchmarks and deliver strong results to our investors.
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