Portfolio Rebalancing and the Re-weighting of International Small Cap (continued)

For accounts where this 80/20 to 60/40 rebalance could be achieved without tax consequences (for example, in an IRA), the change was implemented rapidly. Taxable accounts required a bit more work. Using the 175 basis point premium estimate, we calculated the minimum rate of return expectation to justify selling current overseas large cap positions at a gain and buying overseas small cap stocks with the proceeds. Even at the highest actual gains exposure in clients’ portfolios and considering the minimum long-term capital gains holding period for the performance of the proceeds, the minimum required rate of return advantage was only 1.38% or 138 basis points. Consequently, it made sense to make the move in all cases where the large cap funds had been held for at least one year. In almost all other cases, we determined that it would be best to wait until the current holding period reached 12 months and then do the rebalancing trades.

Implementation of clients’ investment plans involves division of portfolios into various asset classes and, then, sub-asset classes. In the rebalancing process, the first screening is done at the asset class level (large cap domestic, small cap overseas, etc.). If these are within the investment plan’s tolerable limits, the process often stops there. The sub-asset classes (“growth”, “value”, “blend”) are important, but the benefit of rebalancing over its costs is not as clear at this level. And, although we often have more than one manager in an asset class, as a general rule we did not attempt to rigorously equalize the allocation to each manager.

We, of course, took into account the size of the trades and the impact of any transaction fees (often having to weigh fees on both the sale and the purchase). We set a total of 40 basis points as the cut-off for tolerable transactions costs. As a result, we have postponed transactions for some of our smaller portfolios, awaiting any new portfolio inflows to facilitate coming back toward target allocations.

We will complete the annual rebalancing process in August when we address the allocations within the many Section 529 education plans clients began to establish in recent years.