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Better Investment Proposition

Who Are You Rebalancing Portfolios For ?

By 10 November 2021No Comments

If you’re managing portfolios today or using even external portfolio providers, take a minute to think about; WHO ARE THEY REBALANCING PORTFOLIOS FOR? And what is the implication to clients?

There are different philosophies, systems, and investment methods around how model portfolios are authored. It’s critical to understand the different types of rebalancing around those methods.

To simplify, often we find people who are authoring model portfolios. It might be a set of investments with a set of weightings associated with those investments. Sometimes model portfolios are created with the sole purpose of being of generating Alpha; as in the people who are authoring, both their motivation and desired reward may be according to how they can adjust those asset allocations in the market to change and create Alpha. To create an improved performance for the portfolio.

The other part of the puzzle is then in the real-world with actual client portfolios.

Client portfolios are the assets that people hold in their portfolios. Their motivation may be that they just want to leverage the intellectual capital to create Alpha and performance in their portfolio in the same sort of timeframes that this is being authored for.

However, they may have an alternative strategy. One such strategy could be they are looking at a 20-year investment horizon, and they want to get the best result within that investment horizon.

So, what do we see in terms of different rebalancing for these scenarios? 

We find there are essentially three zones:

  1. There is Rebalancing 1 that can happen all around the model, trying to create the active Alpha. So rebalancing in this instance is where the client portfolio is a subject of the model portfolio. It’s about replicating the client portfolio to be like the model portfolio, in order to optimize that act of Alpha creating activity.  

Therefore, trades that are generated through this rebalancing process are essentially the master model we want the client portfolio to be like.  Or a sleeve of the client portfolio to match it.

  1. The second type of rebalancing that has been around for some time is Rebalancing 2 to a recognition that it’s not just about the Alpha of the model portfolio. The client may have some specific rules or preferences that they want to have applied. These are usually in the form of what is called “people with reservations, or exclusions” etc.

The client may suggest that they have some assets in their own portfolios which have additional instructions.  They may create additional rules on various investments ie. those investments are to be maintained, or they are cherished investments or reserved investments, or specific investments in their portfolios that are never to be sold.

Clearly, when the model portfolio goes with those rules, you get a slightly different outcome.  You will not necessarily be going to get the pure Alpha out of the model portfolio because the client has requested that there’s some deviation to that.

However, it’s still very much a process-driven out of the model portfolio that has been authored and the rules in line with that model.

  1. If investors have got a very long-term time horizon, there may be specific situations where the actual adjustments in the model portfolio may not necessarily always be in their best interest. There may be generation of tax liabilities or alternative consequences on the portfolio that may not necessarily support the client’s long-term interest as to what they’re trying to achieve.

In that instance, we end up with what we call Rebalancing 3, where, instead of it being the clients’ portfolio is subject to the model portfolio, it is rather the model portfolio is an input into the client’s portfolio plus their rules, plus their other long-term considerations. Long Term considerations may be ‘don’t realize capital gains’ – as tax is often in many cases the biggest cost of investing. Therefore, the implications are the model portfolio then becomes the guiding light but it’s not the absolute that you see and Rebalancing 1.

With those 3 differing opportunities outlined above, you end up with three very different types of rebalancing depending on what is the specific purpose of the model portfolio.

If the model portfolio is not about active Alpha, but rather it is about long-term strategy, it may be the case that in Rebalancing 3 is appropriate, because you’re never really selling anything, you might just be topping up various holdings or slowing building up positions rather than trying to generate specific Alpha because the client has taken a long-term view.

In summary, you end up with three different types of rebalancing to suite three different types of scenarios. When looking at the rebalancing in your clients’ portfolios, it’s worth asking yourself:

  • Is it Rebalancing 1 where it’s just all about the model portfolio generating Alpha? This may have the best performance, but it might not have the best long term client post-tax performance, or:
  • Is it Rebalancing 2 which is an extension of Rebalancing 1 with a bit more consideration (you said / don’t hit the guardrails), for clients who’ve got particular preferences, or:
  • Is it Rebalancing 3 which is more about the client than it is about the model. The model is a factor that’s been factored into how we review his client portfolio and its long-term interests, not necessarily just the short-term considerations of generating Alpha


Stuart Holdsworth

Author Stuart Holdsworth

Stuart has over 30 years of experience in the use of technology for the strategic competitive advantage of businesses in the financial markets and investment industry.

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