Percentage-range rebalancing
Percentage-range rebalancing and calendar rebalancing are two rebalancing approaches often used by fund managers to determine when to rebalance. Rebalancing an allocation back to its target weights requires more or less constant trading. Constant analysis and trading can lead to high transaction costs and no opportunities to time trades. Rather than set stricter target allocations, managers will generally set allowable ranges.
On this page, we discuss two approaches that investors can use to rebalance. The advantage of having a rebalancing approach in place is that it provides discipline and serves as a form of risk management.
Percentage-range rebalancing
When using a percentage-range rebalancing, rebalancing is triggered by changes in value of the underlying positions. The manager sets what are called tolerance bands or corridors that are considered optimal for each asset class. For example, a corridor of 40% +/- 5% would indicate that the related asset class must stay within a band of 35% to 45%. If the asset class moves outside the corridor, which would mean other classes have also violated their corridors, the portfolio needs to be rebalanced.
By not waiting for rebalancing dates (see the second approach, calendar rebalancing), range based rebalancing provides the benefit that it minimizes the degree to which asset classes can violate their allocation corridors. The approach is more costly because of the large amount of time spent on constantly monitoring the portfolio (as compared to only checking valuations on the specified calendar dates) and by potentially more frequent trading.
When applying range-based rebalancing, the following four questions need to be be addressed by the fund manager:
- Who is responsible for rebalancing the portfolio?
- How often should the portfolio be monitored for rebalancing decisions?
- What is the optimal size of the rebalancing corridors?
- Should rebalancing to target weights be fully or only partially corrected?
Calendar rebalancing
As its name implies, calendar rebalancing is rebalancing the portfolio to its strategic allocation on a predetermined regular basis (e.g., monthly or quarterly). Generally, the frequency of rebalancing depends on the volatility of the underlying positions, but sometimes the rebalancing is scheduled to coincide with review dates.
The primary benefit to calendar rebalancing is that it provides discipline without the requirement for constant monitoring. The main drawback is that the portfolio could stray considerably between rebalancing dates and return to its strategic allocation ranges on the rebalancing date. In other words, rebalancing is only related to the passage of time and not the value of the portfolio.
Summary
We discussed two rebalancing approaches that fund managers can use, percentage-range rebalancing and calendar rebalancing. The optimal width of the corridor is discussed in more detail here.