What rebalancing approach should the IPS specify?

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AcadiFi · Accepted Answer

Rebalancing restores the portfolio to its policy weights after market drift. Four main approaches: 1. Calendar rebalancing. Rebalance on a schedule (quarterly, semi-annually, annually). Simple, predictable, low maintenance. Ignores magnitude of drift. 2. Percentage-range (threshold) rebalancing. Rebalance when any asset class drifts beyond a tolerance band (e.g., ±5 percentage points for equity, ±3 for bonds). Responds to actual drift; involves continuous monitoring. 3. Calendar + threshold. Check on schedule; rebalance only if threshold breached. Combines discipline with cost control. Most common in practice. 4. Dynamic / tactical rebalancing. Adjust toward or away from targets based on forecasts. Not strictly rebalancing — it's active management overlaid on strategic allocation. Requires explicit IPS authorization. Threshold width considerations: - Narrow bands (2-3%) minimize drift but raise transaction cost and tax drag. - Wide bands (5-10%) reduce cost but allow larger deviations. - Typical rule: band width approximately 25% of each asset class's target weight (e.g., 60% equity → ±15% proportional → ±9% absolute is wide; 25% × 60 = 15 wide; most practitioners use ±5-7). ```mermaid flowchart TD A[Drift
Monitor] --> B{Breach
Band?} B -->|Yes| C[Rebalance] B -->|No| D[Hold] C --> E[Tax
Check] E --> F[Execute] ``` Tax and cost overlays: - Use cash flows (contributions, distributions) to rebalance before trading. - Rebalance in tax-advantaged accounts first. - Harvest tax losses when rebalancing taxable. - Avoid short-term gain realization. Behavioral benefit: rebalancing forces selling winners and buying losers — it mechanically implements 'buy low, sell high.' Historical studies show 10-40 bps annual benefit from disciplined rebalancing over buy-and-hold. A concrete example: Melisande Trucco's IPS: 60/40 target, quarterly check, ±5 percentage point bands, use cash flows first, tax-loss harvest on rebalance. After a 2025 equity rally, equity hits 67% in Q3. Trigger. Advisor harvests losses in a small-cap position (-$8K), sells $140K of large-cap index (long-term gain, spread over 2 tax years via November/January execution), buys core bond fund. Portfolio restored to 60/40. CFA exam: IPS should specify the rule explicitly and document tax-cost-management rules.

What rebalancing approach should the IPS specify?

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