Rebalancing optimal corridor width
Fund managers typically use one of two rebalancing approaches when rebalancing a portfolio back to the strategic asset allocation; calendar rebalancing or percentage-range rebalancing. We discuss both approaches here. On this page, we discuss what considerations a manager will take into account when setting the rebalancing optimal corridor width.
Strategic considerations corridor width
The optimal width of the corridor for an asset class will depend on the following criteria:
- Transaction costs: clearly, the more expensive it is to trade, the less frequently the fund manager should trade. If a security is particularly illiquid, for example, trading can be quite expensive. In that case, the corridor for the class should be set wide. As a general rule, the more illiquid the security, the wider the corridor.
- Risk tolerance: more (less) risk-averse investors will generally have tighter (wider) rebalancing corridors.
- Correlations: the more highly correlated the securities (allocations) in a portfolio, the less frequently the portfolio will require rebalancing. Imagine all assets tend to move together. In that case, their values will tend to stay within acceptable ranges. For example, if stocks and bonds both increase 15% in value (assuming only stocks and bonds are included in the portfolio), their weights in the portfolio will probably stay within acceptable limits. However, if stocks increase 15% while bonds decrease 15%, the weights will probably both violate their corridors.
- Momentum: if investors believe that current trends will persist, an argument can be made for using wider rebalancing corridors. Conversely, if investors anticipate mean reversion, tighter rebalancing corridors should be applied. That way, the strategy takes profit in anticipation of a trend reversal.
- Liquidity: illiquid investments, such as private equity and real estate, are typically associated with higher transaction costs. These liquidity costs suggest the use of wider rebalancing corridors.
- Derivatives: rather than selling underlying assets, a derivatives overlay strategy can be used to synthetically rebalance a portfolio. This approach results in lower transaction costs, lower taxes, and can be executed quicker and easier compared to rebalancing with only the underlying stock and bonds. The disadvantages of this approach is that the use of derivatives requires additional risk management when used as a rebalancing tool.
- Taxes: when making rebalancing decisions, taxes should always be considered since realised capital gains and losses will impact investor taxes. Therefore, taxable portfolios will typically set wider rebalancing corridors than tax-exempt portfolios. The corridors may also be asymmetric due to tax savings (i.e. tax loss harvesting). This suggests that the rebalancing range in the case of taxes may be less below a certain target weight than above.
- volatility: higher volatility will most likely call for narrower corridors in order to control risk, but will increase transaction costs.
Summary
We discussed the main criteria that a fund manager should take into account when setting the rebalancing corridor width for a particular portfolio.