Monday, 24 December 2007

My Rebalancing Policy Refined

Readers of this blog may remember (well, you can be forgiven if you don't, I had to look it up myself) that in May I described a wholesale reworking of my portfolio including how and when to rebalance holdings back to a target asset allocation within the total portfolio. My best available information at the time was Richard Ferri's book All About Asset Allocation, so my rebalancing method was based on his recommendations. Then I came across a great article by David M. Smith and William Desormeau on the topic through a posting on Larry MacDonald's blog and wrote about the surprising findings. As a result I've decided to refine my policy on rebalancing.

The New Policy:
  • review portfolio actual market value vs target allocation ( target = the percentage each holding is to have within the total portfolio) once a year in December
  • purchase or sell holdings required to rebalance to target percentage of total portfolio if total bonds (funds and ladder combined) vs equities has moved more than 5% away from target; currently my bond target is 30%, so if bonds go up to 35% or down to 25% (the corresponding numbers for equities - all of them, domestic, foreign, real estate, commodities - is 70% up to 75% or down to 65%)
  • rebalance only those holdings where the transaction cost is less than 1%, currently that would be a trade of $1000 since my transaction cost is $9.95 or where a tax loss selling opportunity in the taxable account makes a trade worthwhile
The new elements are highlighted in italic.

Why the Changes?
  • the move to doing the review in December is to do it at the same time as tax loss selling, to kill two birds with one stone and to minimize trading;
  • the 5% or more deviation test is the major change, coming directly from the findings of the article; though I could have simply eliminated the yearly review and applied the 5% test at any time throughout the year, I still want to do an annual review of my portfolio, my net worth, the tax situation, decisions about RRSP conversions or withdrawals, perhaps a fundamental alteration of the portfolio targets (which is not the same as rebalancing). In the practical world, rebalancing has to contend with, and fit with, lots of other ofttimes more powerful financial forces;
  • tax loss selling on its own may justify a trade, so the opportunity to rebalance fits naturally.
Incidentally, one thing I have seen mentioned as a problem to do rebalancing based on percentages is one no longer. Formerly, it would have been a lot of work to constantly track a portfolio and actual vs target percentages but that is no longer an issue. Google's wonderful online spreadsheet with constantly updated market values for the holdings, including a good-enough kludge to calculate the foreign exchange component, does it for you. I have placed a Google spreadsheet at the bottom of this blog that replicates my portfolio structure and tells me at any given minute-hour-day the portfolio value and target vs actual percentages so I can see where I have gains or losses and how much they are (I have to apply a multiplication factor to convert the model into my own total but that's not too difficult).

What I Still Wonder About
Unlike the researchers' model portfolio of two holdings - stocks and bonds - my real portfolio contains 16 different holdings (more, if my bond ladder is broken down). Most are quite small - 5% or less; only three are 10% or more (see the Asset Allocation tab in the Google spreadsheet). Several, especially REITs and commodities, are supposed to be volatility reducing with very low or negative correlation to the mainstream equity holdings. It means they are likely to go up while the mainstream equities go down. So, the question is when or if to rebalance in the case that the overall equity total is within the 5% limit (i.e. it says don't do rebalancing at all) but one of the minor holdings has doubled for instance. I don't want to be arbitrary to go back to the days of doing things by "feel" so I need a rule and a good reason for that rule. Perhaps I need not worry, though. Seven months after my portfolio revamp, the most any individual holding has strayed from its target is Vanguard's European Equity (VGK), down only 1.2% despite being hammered by the rising Canadian dollar, which has been almost as strong against Sterling as against the US dollar.


Anonymous said...

Well, you are ahead of me - I'm still working at the asset allocation thing. I've decided to more simple than originally planned and will probably adopt a rebal plan like the one you just mentioned since it's seems pretty reasonable.


Anonymous said...

Gostei muito desse post e seu blog é muito interessante, vou passar por aqui sempre =) Depois dá uma passada lá no meu site, que é sobre o CresceNet, espero que goste. O endereço dele é . Um abraço.

John said...

Great views on rebalancing

Is your main portfolio an RRSP?

Why I ask is that I try and rebalance in terms of tax efficiency. I try and put pure Canadian dividends in the “outside RRSP” accounts and keep the bonds, Trusts and International stuff inside the RRSP.

Rebalancing becomes a tax problem as my outside the RRSP portfolio is 2X the inside.

CanadianInvestor said...

My registered accounts are close to 90% of my holdings so I have a different problem than you - if I was to try rebalancing now the rebalance purchases would all be in my non-reg account - things like VGK and VNQ and the sales would be in my reg accounts, where fixed income is up relatively speaking. I do not want to remove funds from the RRSP merely to rebalance so a new less active rebalancing policy helps.

The cap gains taxes for you might well outweigh the rebalancing benefits, another reason for less frequent rebalancing. Certainly, eligible dividends are good to have outside due to their being the lowest tax rate. As I said in a recent post, maybe the trick is to make part of your fixed income outside using preferred shares - dividend income with good tax treatment. Bonds and those preferreds that most behave like bonds, would have weak- or negative -correlation with many equity assets. Thus, maybe rebalancing time could see one going up and the other down, creating losses to offset gains.

These days, however, it just seems that most everything is going down, just some faster than others.

John said...

Great points – thank you

We are on opposite paths in the sense that I am looking at VGK for inside the RRSP.

This is a bit off the rebalancing topic but how did you decided between VGK and something like TDB902?

I started by thinking that VGK was better as the MER for Vanguard was so low. Then it hit me that TD and others charge 2% to convert in to US $ before you buy the VGK.

Even if I use a TD borderless account to convert to US$ it is still more then 1%.

So my logic said that buying TDB902 was a better deal in the first 2 years of MER were “free” give my savings on the initial currency conversion.

This may not be true as I then compared
US Index - TDB902
US Index ($US - TDB952
US Index Currency Neutral - TDB904

I then noticed that the US Index in US$ and the US Index Currency neural had different return rates. So I suspect that TD and others charge a hidden currency conversion?

Michael James said...

Thanks for the clear post with your thoughts on asset allocation. I've been reading many of these lately, and there is one thing that bothers me. Why put money that you won't need for at least 5 years in bonds if the odds are very high that stocks will give a higher return? I wrote an essay recently that explains my thinking more fully.

My thoughts aren't set in stone. I'd love to hear good counter arguments. I've read so much advice on this topic that never seems to address my objection.

CanadianInvestor said...

Great question. I believe the answer lies in various risks, i.e. uncertainties about returns, about one's need for cash, about timeframes. Will post on this next week when I'm back in Scotland.

btw, like your blog and have added a link in my blogroll.

CanadianInvestor said...

Re your last comment 31 Dec.
My reasons for VGK over TDB902. 1) to buy TDB you need to have an account with TD and my holdings for now are with BMOIL; didn't want to open a TD account just for that 2) for other holdings in reg accounts where I did have to buy US$ (VGK itself was in my taxable account), I figured the average cost of the FX over a number of years would be overcome by the lower expense ratio 3) though I didn't know at the time I did the trades, BMOIL will do wash trades (i.e. not charge the FX conversion) when it is all done the same day, which is what I normally do when rebalancing 4) Questrade just announced they will allow US$ cash holdings in reg accounts and I hope/expect that BMOIL and the other big bank brokerages will soon follow suit.

Thanks for the notes on the other TD funds. I had not been aware of the performance differences. I'm sure as you suggest that at least part of it is due to the FX conversion costs in the currency-neutral/hedged versions. We can be sure that all costs are passed along to us investors and that the management fees are not diminished in the slightest, probably even higher due to the extra complication.

dj said...

re: re-balancing smaller holdings.

As you have noted a 5% absolute change in larger holdings works well but for small holdings doesn't make sense.

That is where using a relative change is useful and using wide limits would avoid too frequent re-balancing. (ie. 25 or 33%)

I am currently using 5% absolute and 25% relative, whichever is smaller. (along with a 1% commission rule)

CanadianInvestor said...

dj, interesting... how long have you been doing that and often has it resulted in you making trades? As I look at my own portfolio, the closest a holding would be to rebalancing is VGK, the Europe ETF and that's not even a year on. A lot of that is due to currency appreciation of the C$ against the £.

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