Artful Account Rebalancing

by David Tepp, CPA, PFS, MBA, Tepp Financial Planning – July 20, 2020
Artful Account Rebalancing

One surefire way to initiate an awkward discussion with a client is to advise selling off part of an investment that is earning an excellent return. Particularly during bull markets, seldom does proper account rebalancing lead to improved near-term rates of return. Instead, the objective of rebalancing is to reduce the risk within a portfolio. 

Security Selection and Portfolio Testing

Before selecting individual securities for a portfolio, investment correlation should be carefully considered. For example, large cap and mid cap equities have a relatively high positive correlation, so shifting assets from one to the other may not reduce the client’s risk. However, shifting from equities to certain bond securities where the correlation is lower will likely reduce risk.

Once you have assessed the client’s risk tolerance and constructed a portfolio, it is critical to analyze how it would have respond­ed to past financial crises. Investment analysis software can enable you to calculate how the portfolio would have performed during the COVID-19 outbreak, the 2008 mortgage crisis and the 2001 tech bubble, to name a few. Once the portfolio is stress tested, the investment manager should then analyze security correla­tion and adjust the holdings as necessary to reduce risk.

Timely Rebalancing

Investment managers will often choose to rebalance quarterly, semi-annually or annually depending on the size of the account. Howev­er, far more important than the time interval is the timeliness of rebalancing. The primary objective of all investors is, naturally, to “buy low and sell high.” Rebalancing accounts based on price volatility enables the investor to trim holdings that have grown beyond their intended target (selling high) and acquire less expensive diversifying assets (buying low).

For volatility-focused rebalancing, it is critical to establish parameters that trigger activity only when appropriate. Overly sensitive parameters will result in heavy trading that can increase costs. Alternatively, if the parameters are too broad, the account will drift beyond the intended allocation and increase risk.

“Account rebalancing should be designed to evaluate the account perpetually but to trade only when necessary,” says Dan Skiles, president of Shareholders Service Group, a San Diego-based broker-dealer which specializes in serving independent advisors. “Further, it is critical to have trading desk support that can assist advisors with estab­lishing model portfolios and determining best practices.”

Mitigating Taxes

For taxable investment accounts, the obvious initial objective when rebalancing is to avoid generating too high a tax liability for the investor. When taxable accounts have positions with unrealized losses, the investor can sell these investments, wait for the wash sale period to end and repurchase the assets within the same account. This generates a useful capital loss while enabling the investor to continue holding the desired securities, albeit with a reduced tax basis.

The greater challenge is when the account has accumulated gains, particularly to such a degree that it enhances the inherent portfolio risk. When this occurs, it is necessary to do two things simultaneously: strategically reduce the position of the inflated asset, and look for sale opportunities throughout the year that will generate losses which can offset the gains from the previous step.

Sachin Shah, chief operating officer of 55ip, a Boston-based software company that engineers automated investment rebalancing strategies for financial advisors, recommends a three-step approach:

  1. A tax-prudent transition that pivots clients from their current strategy to one that is better aligned to their risk profile while adhering to a specific tax budget established by their CPA.
  2. Ongoing tax management that entails tax gain and loss harvesting throughout the course of the year.
  3. Tax-focused withdrawals which enable clients to access funds without accruing a heavy tax liability.

The need for consistent rebalancing was readily apparent earlier this year when financial markets fell sharply due to the COVID-19 out­break. Disciplined investors rebalanced their portfolios after the S&P fell by nearly 30 percent. Rebalancing at that point was unusually tricky since virtually every security type lost value during the collapse. Yet, adhering to the target allocation enabled investors to acquire high-value securities at bargain prices.

Throughout this process, client communication is critical. It falls upon the investment manager to explain why rebalancing is necessary even though it may adversely affect investment returns during bull markets. The conversations may be difficult, but the benefits are especially apparent during retractions.

David L. Tepp

David Tepp, CPA, PFS, MBA, is the managing member of Tepp Financial Planning, an independent wealth management firm in Westfield, New Jersey. He is a member of the NJCPA.

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This article appeared in the July/August 2020 issue of New Jersey CPA magazine. Read the full issue.