Better Than Rebalancing Based On Tolerance Ranges!

Wednesday, September 19, 2012 02:51
Better Than Rebalancing Based On Tolerance Ranges!

Tags: advisor technology | asset allocation | investing | portfolio construction | rebalancing

Whether advisors are rebalancing by hand, with spreadsheets or with rebalancing software like Total Rebalance Expert®, they typically rebalance based on tolerance ranges.

A tolerance range sets the high and low bars for particular holdings in clients’ portfolios.  How do advisors choose these ranges?  They tend to choose the range – commonly plus or minus 20% - to maintain the chosen investment allocation while optimizing the number of transactions.  In other words, the range is chosen based on a subjective opinion of what is “too far out” while ensuring that trades are not initiated too often.

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While this strategy has apparently worked for most advisors, it might not be ideal.  Because advisors construct models to achieve risk/return efficiency, allowing standardized tolerance ranges might not result in appropriate maintenance of the target risk/return.  For example, it is possible that allowing a 20% deviation in a higher risk investment could result in a material impact on the portfolio’s risk/return profile more so than a 20% deviation in a lower risk bond fund.
When proposing rebalancing trades, what if a particular trade produces a large taxable gain?  Would the advisor be inclined to not make the trade if the risk/return composition would not be materially impacted?
A tool like MacroRisk Analytics® can provide this type of information.  Yet, relying solely on risk analysis software might be cumbersome. Consider a combination of methodologies – rebalancing based on tolerance ranges as targeted or adjusted based on risk analytics.  A system combining MacroRisk Analytics and Total Rebalance Expert offers advisors the opportunity to compare a risk measure, the Composite MacroRisk Index (CMRI), for the “before” and “after” portfolio, the “before” portfolio and the “target” portfolio, the “after” portfolio and the “target” portfolio, or a combination of all of the above.  Additionally, the CMRI can be used to compare models, alternative funds, etc. 

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