Rebalancing works, but it’s also costly

The Investment Reporter,, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

Rebalancing leads to trading costs. These include brokerage fees when you sell one investment and reinvest in another, bid-ask spreads and taxes on realized capital gains.

Rebalancing is a smart strategy. It lets you side-step the trap of portfolio drift (where changes in market prices change your asset allocation). Instead, rebalancing keeps your portfolio balanced and at your desired asset allocation targets. This should help you sleep at night. Rebalancing also enables you to profit from contrarian investing. But unfortunately, rebalancing is costly.

One cost of rebalancing is that you incur brokerage fees. You pay one fee to sell high-priced investments and another to buy low-priced investments.

Less obvious, you lose to the bid-ask spread. That is, when you sell, you’ll likely receive the lower bid price. When you reinvest, you’ll likely pay the higher ask price. You could hold out for the ask price when you sell and the bid price when you buy. But this is apt to cost you even more in lost investment opportunities. This seems particularly true of the NASDAQ stock exchange in the U.S.

Keep unrealized gains working for you 

A third cost with rebalancing is the income tax you pay on realized (or taken) capital gains. Since you’re selling investments that have mostly gone up, you’ll likely face gains. The exceptions are when you take profits in tax-deferred accounts such as your Registered Retirement Savings Plan, Registered Retirement Income Fund or Tax-Free Savings Account.

Mr. Warren Koontz Jr., vice-president and treasurer of The Jeffrey Company has written, “The value of unrealized gains is often overlooked. Unrealized gains are the portion of a portfolio’s principal growth that has not been realized and diminished by taxes. The longer the gains remain unrealized, the more valuable they are, because deferred taxes on unrealized capital gains compound for the investor instead of Uncle Sam.” The same applies in Canada.

Keeping unrealized capital gains working for you makes sense. Outside of tax-deferred accounts, this means using a buy-and-hold strategy. Critics say ‘frozen’ buy-and-hold portfolios earn lower returns. They say that buying and selling is needed to earn higher returns. But the evidence shows that buy-and-hold portfolios usually do better.

Professors Josef Lakonishok, Andrei Schleifer and Robert Vishny examined whether money managers can raise the returns of actively-managed funds. They found that on average, buy-and-hold portfolios beat actively-managed ones by 0.78 per cent a year—excluding taxes, management fees and cash holdings (which hurt the returns of actively-managed funds). Lakonishok, Schleifer and Vishny concluded that the trading of active managers hurt the performance of their funds. No wonder unmanaged exchange-traded funds are have become so popular.

Still, you can reduce the costs of rebalancing by tying it to your ordinary investing

Rebalance throughout the year

Given the costs of rebalancing your portfolio, we advise you to tie your rebalancing to your investing program. The fact is, fixed-income investments mature and you earn interest and dividends. Some of your companies will face takeovers, you’ll have money to invest and so on.

Let’s say that you’re still building your portfolio. Then you should reinvest cash you receive plus any money you add in a way that rebalances your portfolio. While you’ll incur costs from doing so, these are costs that you would’ve faced anyway.

If you’re a retired investor, you may have no need for investment income—particularly if you’re lucky enough to belong to a generous defined benefits pension plan. You, too, can rebalance as you reinvest the cash that your portfolio generates. Again, there are no added costs to such rebalancing.

Other retirees, by contrast, need to withdraw money from their portfolios. If this is your situation, then sell in a way that rebalances your portfolio.

For instance, with stocks slightly outperforming bonds in the first half of 2013, you could lower your exposure to stocks by selling some to raise the money you need. This will move you closer to your desired asset allocation. Consider selling stocks in the sectors that have done the best.



The Investment Reporter,, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

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