Advisors Prescribe Regular Portfolio Rebalancing

By

Advisors say that if a client’s financial plan is to work like a fine Swiss watch, then it is important to periodically recalibrate mutual fund holdings that make up that plan.

Year-end is as good a time as any to rebalance mutual fund holdings, although there is a consensus that a particular time is not as important as the fact that it gets done.

An annual evaluation is important and year-end can be a convenient time of year to rebalance fund holdings, according to Harry Greyard, a certified financial planner with Waddell & Reed in Charlotte, N.C.

When and how funds are rebalanced depends on when a client is going to need the money, Greyard says.

If a client is 20 to 30 years away from retirement, it is important to revisit the portfolio, but it is not as critical as if someone is near retirement and will need that income to live on.

Two factors he considers are the client’s need and risk tolerance. Rebalancing is important because it helps maintain diversification, he adds.

However, care needs to be taken to ensure that rebalancing does not become the focus. “Your long-term goal is what is important. Rebalancing is what helps you get there,” Greyard continues.

David Cowles, a certified financial planner with Boone Financial Advisors in San Francisco, says rebalancing is an important tool for his firm because of its focus on asset allocation.

While year-end rebalancing of a client’s mutual fund portfolio is one approach, he says immediate action may be a better tack.

For example, he explains, if your client ends up with 80% in mutual fund equities in July and you wait the five months until year-end, “if the market falls out of the cradle, you’re taking a big loss.

“That’s why you hire us–for the discipline of rebalancing,” he says. Allocation goes against human emotion and enforces the idea of selling high and buying low, Cowles adds.

However, he continues, rebalancing mutual fund portfolios comes at two costs: a tax and a transaction cost.

Cowles says tax costs can be minimized by rebalancing within an IRA account.

He also recommends that advisors “harvest losses” and apply them against capital gains and taxes from ordinary income.

If, for example, you have $20,000 in losses and you have $3,000 in taxes from ordinary income, you can use the loss to offset income, Cowles says. You can carry the $17,000 loss into the next year, he continues. However, capital gains must be offset first before the total can be applied to taxes from ordinary income, he says.

Transaction costs are another issue that must be considered when rebalancing, Cowles says. If there is a movement of 5% from a client’s target, then the mutual fund portfolio is rebalanced, Cowles says.

Joe Sciabica, a certified financial planner in New York, says rebalancing should be done at least every other year, but does not need to be done annually unless something goes awry with a client’s investment plan.

He says rebalancing is an important consideration, but notes the possible tax effect outside of a tax-deferred retirement account such as a 401(k) plan.

That being said, Sciabica cautions advisors to rebalance when necessary and not let the tax tail wag the dog.

If a tax loss is going to be incurred, an advisor must consider whether a client will be able to use that loss, he adds.

Sciabica says that if the fund that is being rebalanced has experienced an overall loss but has sold securities itself, then a client might face the double disappointment of posting a loss and having to incorporate in the sale the fund’s tax expense on the capital gain.

While he says that he is not advocating market timing, Sciabica says if you are going to sell a fund anyway, then it is worth looking at publicly available information to sell prior to a date when such an expense would be incurred.

Once a fund is sold, whether the proceeds are invested in another fund or in an individual security would depend very much on the size of the asset, Sciabica says. If the asset is less than $50,000, then it is better to stay invested in mutual funds, he says. “If you don’t have enough buying power to diversify, then you should invest in other mutual funds.”

Roger McCullough, a qualified plan specialist affiliated with AXA Advisors in Fort Dodge, Iowa, says a client’s risk tolerance will help determine whether a mutual fund portfolio should be rebalanced. He says many clients think they are risk tolerant and find out differently during a volatile market.

As McCullough puts it, “All men would be matadors if the bull had no horns.”

Clients often rebalance a portfolio by leaving existing investments alone and investing new money to bring risk tolerance in line with what they can handle, he says.

He says younger clients tend to be more optimistic and less conservative given not only a longer time span until retirement but also a lower amount to invest.

It is an entirely different discussion if someone invests $1,000 and it goes to $500 than when someone invests $100,000 and it declines to $50,000, McCullough adds.


Reproduced from National Underwriter Life & Health/Financial Services Edition, December 17, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


Copyright 2001 by The National Underwriter Company. All rights reserved. Contact Webmaster