Insights From ETFs The Power of Rebalancing: How Exchange-Traded Funds Can Help Facilitate Portfolio Maintenance
Maintaining a well-balanced and diversified investment portfolio is a key lesson in successful investing. While most investors start out with a well-planned targeted portfolio, market value fluctuations and Exchange-Traded Funds (ETFs) changes lead to deviations from the intended targets. This makes portfolio rebalancing more important to ensure the current allocations reflect investor’s expectations and required exposure.
While it may sound effortless and trouble-free to let winners win and losers lose in the portfolio in the short term, letting it go would mean a different risk profile for your portfolio than you intended. The purpose of rebalancing is to manage risk, not maximize returns. Rebalancing is not to time the market, but it may reduce the volatility in your investment portfolio. In this article, we will dive into the concept a bit more and discuss the role of ETFs in this process.
Understanding Portfolio Rebalancing
In simple terms, portfolio rebalancing is the practice of realigning the proportions of different assets in a portfolio to bring it back to the desired allocation. The process aims to ensure that the risk and return profile of the portfolio remains consistent with the investor’s goals and risk tolerance. Rebalancing involves selling outperforming assets and purchasing underperforming assets.
Source: Canadian MoneySaver
Why Rebalancing Matters
Over time, some assets in a portfolio may outperform others, leading to an unintended shift in asset allocation. Rebalancing helps control risk by preventing the portfolio from becoming overly concentrated in a particular asset class. This risk management may seem unproductive in an upmarket, but it becomes particularly crucial during market downturns.
Additionally, rebalancing ensures that the portfolio remains aligned with the investor’s original objectives. As markets evolve and asset values change, an investor’s goals and risk tolerance may remain unchanged. Rebalancing helps maintain the portfolio’s original investment objectives, ensuring that it doesn’t deviate significantly from the intended path.
Rebalancing isn’t just about risk management and minimization, it also has the potential to optimize returns. The process enforces the discipline of selling appreciated assets and buying undervalued ones. This dynamic allows investors to capitalize on market fluctuations and potentially enhance returns over the long term.
Role Of ETFs In Portfolio Rebalancing
ETFs offer unique benefits when it comes to portfolio rebalancing:
Diversification: Many ETFs offer exposure to broad market indices or specific sectors. This inherent diversification aligns with the goals of portfolio rebalancing, helping investors achieve their target allocations across different asset classes. Many ETFs have specific rebalancing periods in a year to ensure that the ETFs are rebalanced to their mandated targets.
Low-cost: ETFs are known for their cost efficiency. Rebalancing using low-cost ETFs minimizes transaction costs that would otherwise happen if an investor were to rebalance individual stock positions.
Precision: ETFs help investors to fine-tune allocations. Sometimes, a share price might be so high that a change in even one share can impact its overall weight in a portfolio. An ETF, in a way, offers exposure to fractional shares, which can make it easier to rebalance allocations.
The Rebalancing Process:
The process of portfolio rebalancing involves several key steps, including:
Establish a schedule: An investor must determine a rebalancing schedule that suits their investment strategy. This may be in the form of common intervals such as quarterly, semi-annually, or annually, or a moving target such as if the allocations have deviated by five per cent from target weight,
Review: This step involves periodically comparing the current allocation to the intended allocation and identifying deviations,
Allocation adjustment: Based on the review, the next key step is to make necessary adjustments to the portfolio. Selling over-weighted assets and buying under-weighted ones helps to restore the original allocation. This step involves strategic decision-making to align the portfolio with the desired asset mix, and
Tax considerations: Be mindful of tax implications when rebalancing, as selling appreciated assets could trigger capital gains.
Conclusion
Portfolio rebalancing is a proactive strategy that helps investors maintain the desired risk and return profile of their investments. ETFs have enhanced the way rebalancing can be conducted by offering liquidity (compared to mutual funds), diversification, and cost efficiency (compared to stocks). Whether an investor is focused on achieving long-term financial goals, managing risk, or optimizing returns, ETF-facilitated rebalancing provides a dynamic tool to navigate the investment landscape that can change fairly quickly. By harnessing the power of ETFs in the rebalancing process, investors can achieve an alignment between their investment objectives and the composition of their portfolios. Consistent, disciplined, and well-informed rebalancing, supported by the attributes of ETFs, can offer resilience in an evolving market environment. As markets continue to evolve and change, ETFs remain a valuable tool in helping investors achieve their investment objectives through strategic rebalancing.
Disclosure: Authors, directors, partners and/or officers of 5i Research have a financial or other interest in XIT and ZRE.