Types of Rebalancing Strategies

A rebalancing strategy measures risk and return relative to the performance of a target asset allocation (Leland, 1999; Pliska and Suzuki, 2004). The decisions that can ultimately determine whether a portfolio’s actual performance is in line with the portfolio’s target asset allocation include how frequently the portfolio is monitored; the degree of deviation from the target asset allocation that triggers a rebalancing event; and whether a portfolio is rebalanced to its target or to a close approximation of the target.

While complex indicators can be used to trigger rebalancing events, we will focus on the 3 commonly-used strategies used today: “time-only,” “threshold-only,” and “time-and-threshold” based rebalancing.

Strategy #1: ‘Time-only’

In a “time-only” strategy, a portfolio is rebalanced at a predefined or fixed time interval—hourly, daily, monthly, quarterly, etc. The only component in this rebalancing strategy is time, and rebalance events are fixed and occur on specified dates.

An example of a time-only rebalancing strategy would be if you wished to rebalance on a 24-hour interval. This would mean that every day at the same time, you would execute a rebalance.

Strategy #2: ‘Threshold-only’

In a “threshold-only” strategy, a portfolio is rebalanced when an individual asset in the portfolio reaches an allocation percentages which is further away from the target allocations than the threshold. Once the desired rebalancing threshold is achieved, the entire portfolio is rebalanced to maintain the originally desired allocation ratios. The only variable in this rebalancing strategy to account for is the threshold, or the amount of allowable drift within a portfolio.

Since threshold rebalancing occurs only when a specific asset allocation has been achieved, there is no given frequency for threshold rebalancing. Low-threshold portfolios (ie. 1%) are likely to experience more rebalancing events than high-threshold portfolios.

As an example, imagine we have a portfolio with 5 assets which each have a target allocation of 20%. If we desired a threshold of 5% to trigger rebalances, this would mean if the current allocation of any asset exceeded 21% or dropped below 19% of the total portfolio value, then the entire portfolio will be rebalanced.

Learn more about threshold-only rebalancing here.

Strategy #3: ‘Time-and-threshold’

In a “time-and-threshold” rebalancing strategy, a portfolio is instructed to rebalance on a scheduled interval, but only if the portfolio’s asset allocation has drifted and achieves the desired rebalancing threshold (such as 1%, 5%, 10%).

For instance, let’s take an index fund which uses a quarterly rebalancing strategy with a 5% drift threshold. If we reached the end of the fiscal quarter Q1 2019, and we found that the largest drift in the portfolio for an individual asset was only 4%. Based on the fund’s rebalance triggers, the index will not rebalance since the drift for any given asset in the portfolio must exceed 5% when the portfolio is evaluated at the end of the quarter.

Let’s evaluate our previous example (quarterly rebalancing/5% drift threshold) in a different scenario. Let’s say an individual asset in the index drifted by 8% towards the beginning of the first quarter, but by the end of the quarter settled at an only 3% drift. Since the threshold requirement was not met on the rebalancing date, the index will not rebalance as the threshold must be met on the exact rebalance date, and not any intermediate time interval.

In short, time-and-threshold index rebalancing only occurs when BOTH conditions are met.