How to Systematically Rebalance Your Portfolio to Capture Additional Returns
Many experts encourage investors to employ a passive investment strategy by buying total market index funds and holding on to them for the long run. This own-the-market, buy-and-hold strategy is definitely preferable in comparison to most active-management investment strategies, which have statistically been shown to trail the market, especially after fees are considered.
However, this does not mean that it can’t be improved upon! One powerful way investors can increase returns is by segmenting their portfolio into independent components, and then rebalancing between those components as they move up and down relative to each other. The investor still effectively owns the market, but they can now sell positions when they are at a premium, and buy positions when they are at a discount. By systematically selling high and buying low, an investor can manufacture returns that the market itself did not provide.
To understand how this works, it’s helpful to compare the two strategies:
Systematic Rebalancing vs Buy-and-Hold
Imagine two investors, both wanting 100% exposure to the US equities market:
The Buy-and-Hold Investor buys a single Total US Stock Market Index Fund. They own everything, but their allocation to specific positions is dictated entirely by market cap. If Tech stocks double while Energy stocks retreat, their exposure to Tech grows while their exposure to Energy decreases. They have no ability to sell Tech when it is trading at a premium, or buy Energy while it is trading at a discount.
The Rebalancing Investor buys the same total US stock market exposure, but slices it up into various components, such as by economic sector: Tech, Energy, Healthcare, Financials, etc. When the Tech sector soars and Energy stocks tank, they are able to harvest the gains in the Tech sector and reinvest them in the discounted Energy sector, earning a premium.
While both investors effectively own the market and are able to capture the market return, the rebalancing investor earns an additional premium by systematically harvesting the gains and discounts that naturally emerge due to market volatility. Historical analysis has shown that rebalancing between volatile, independent sectors typically adds an extra 0.5% to 1.5% in annual return.
This article walks through the four key steps to an effective rebalancing strategy, as well as how to implement it in a tax-efficient way.
Step 1: Slice the Market into Individual Segments
To capture the rebalancing bonus, the investor first needs to slice the asset class into segments that can be bought and sold independently. For the purposes of this article, we will focus on the asset classes of stocks (equities) and bonds (fixed income). While there are many ways to segment stocks and bonds, here are some of the most common:
By Industry Sectors (stocks): Tech, Healthcare, Energy, Utilities, Real Estate, Materials, etc
By Geographic Regions (stocks): US, Canada, Europe, Asia-Pacific, Emerging Markets, etc
By Style & Factor (stocks): Growth, Value, Small-Cap, Large-Cap, etc
By Maturity (bonds): Short-Term, Intermediate, Long-Term
By Credit Quality (bonds): Treasuries, Investment Grade, High Yield, etc
By Issuer (bonds): Treasury, Agency, Mortgage-Backed, Corporate, Municipal, etc
By Security: Owning each individual position (aka direct indexing)
Whatever the segmenting strategy, the goal is the same: own the market in a way that allows individual segments to be bought and sold independently. In order for this segmentation to be effective, the individual segments should be:
Publicly traded: Readily accessible in the public markets.
Inexpensive: Reasonably priced with low expense ratios, no hidden fees, etc.
Imperfectly correlated: Priced independently so that they do not rise and fall in lockstep.
Thankfully, the proliferation of passive, low-cost, tax-efficient exchange-traded funds (ETFs) over the last few decades has made it relatively straightforward to segment almost any market.
Step 2: Establish a Target Weighting for Each Segment
Once the investor has decided on a segmentation strategy, they need to establish a target weighting for each segment. Note that this target weighting cannot simply be the market-cap weighting, or else there would never be any rebalancing opportunity: If Tech is purchased at its market-cap weighting, it will remain market-cap weighted from that point forward, so a market-cap target weighting would never call for any rebalancing. Another way of saying this is that a market-cap target weighting is indistinguishable from buy-and-hold.
Instead, the investor needs to establish a strategic target weighting that is independent from and more stable than the market-cap weighting. This is so that when Tech is up and Energy is down relative to the target, we can harvest that volatility by rebalancing Tech and Energy back to their more stable targets.
Generally speaking, there are two types of targeting strategies:
Fixed (Stationary) Strategies: These set a permanent target for each segment. The simplest strategy is Equal-Weighting (allocating the same percent to each slice) but there are a variety of other methods for selecting fixed targets. While fixed strategies are simple to execute, their primary drawback is that they provide no safety valve for dying industries, encouraging the investor to keep pouring money into a declining sector even if it is becoming obsolete.
Dynamic (Adaptive) Strategies: These adjust the target weighting based on changing market data. While Trend-Following (using historical moving averages) is the most common, there are a variety of ways to incrementally update target weightings based on how the economy evolves over time. These ongoing target refinements prevent blindly rebalancing into industries that are in permanent structural decline.
Note: Establishing a target weighting between asset classes (ie stocks vs bonds) should be based on the circumstances and preferences of the investor - their risk tolerance, time horizon, income needs, etc - not on the market-driven factors outlined above.
Step 3: Monitor Each Segment Relative to its Target
Once target weightings have been established for each segment, the investor needs to monitor each segment’s performance relative to its target, and determine how far away a segment is allowed to drift before it is rebalanced back to the target. This is a balancing act - the investor doesn’t want to rebalance every time a sector moves by 1%, but if they wait too long, they may miss out on opportunities to harvest the rebalancing premium. The two most common timing methods are:
Calendar-based, which involves checking the portfolio on a set schedule, such as every six months or once a year. While simple, the downside is that a massive market move might happen in February, but the investor won't react until their scheduled rebalance in December, missing the chance to buy the dip.
Rebalancing bands are a more responsive approach where the investor establishes a tolerance around their targets, and delays rebalancing until the segment grows or shrinks beyond that tolerance window. For example, if a segment's target is 10% of the portfolio, and the rebalancing band is set at 20%, the segment can grow to 12% or shrink to 8% before it is rebalanced.
Rebalancing bands ensure that segments are rebalanced only when the market has moved enough to justify the effort. It allows the "winners" to run a bit further before being sold, and the "losers" to get significantly cheaper before being purchased. This prevents over-trading while ensuring the investor captures sizeable price swings.
Step 4: Rebalance Segments Back to Their Targets
This is when the rebalancing premium is actually harvested: the investor sells the segments that have outperformed and buys the segments that have underperformed. In doing so, they are essentially betting that winners don't win forever and losers eventually recover. And they are taking advantage of the inherent volatility of the markets to improve their returns.
It should be pointed out that this can be challenging for investors: it requires them to sell popular sectors that are in demand (the stuff everyone is talking about), and buy unpopular sectors when they are on sale (the stuff no one is interested in). In a very real sense, this can feel like they are swimming against the tide, watching everyone else get in on the “next big thing” while they get stuck with the boring stuff.
In reality, those trend-following investors are statistically very likely to pay a premium to jump into the hot sectors, only to watch those hot sectors revert to the mean (or worse, crash). To add insult to injury, to fund their expensive purchases, they likely would have sold out of some seemingly boring sectors, right as those sectors were poised to recover and revert back to their mean.
This swimming-against-the-tide is why rebalancing needs to be systematically implemented instead of emotionally driven. Without a robust system in place to tell the investor that it's time to sell the hot stuff and buy the boring stuff, emotions can take over and cause people to make expensive mistakes.
Is Rebalancing an Active or Passive Investment Strategy?
For the buy-and-hold, passive investor, it can sometimes seem like rebalancing is an active investment strategy. And certainly, systematic rebalancing does require active involvement from the investor, to slice the market, set targets, monitor performance, and periodically rebalance.
However, it would be inaccurate to characterize systematic rebalancing as active investment management. Generally speaking, this is because:
Active management is predictive, requiring the investor to make forward-looking judgments about which specific stocks or sectors will outperform in the future. It relies on economic forecasting, market timing, and human intuition to find mispriced opportunities. Success depends on the accuracy of the investor's opinion.
Systematic rebalancing is reactive, a purely mechanical response to what has already happened. It uses fixed mathematical triggers rather than predictions. There is no attempt to "beat" the market through cleverness; instead, the investor simply adheres to a predetermined set of rules that forces them to buy low and sell high across segments.
While an active manager might change their mind based on the morning news or a shifting "gut feeling," a rebalancing strategy removes the investor’s ego from the equation. It is a disciplined form of passive investing that ensures the investor maintains their intended exposure regardless of the prevailing market sentiment.
Doesn’t Selling Winners Generate Significant Taxes?
When an investor sells a segment that has increased in value to capture the rebalancing premium, they realize a capital gain. If these transactions occur in a taxable brokerage account, the investor owes capital gains taxes on that profit, which introduces a drag on the portfolio's overall return. This presents an inherent conflict: the very mechanism designed to generate additional returns (selling high) simultaneously generates a tax bill that can dilute or even erase those additional returns.
Thankfully, there are a variety of ways the investor can minimize or even eliminate the tax drag that systematic rebalancing might incur. These strategies include:
Rebalancing with Contributions: Instead of selling winners, investors can direct new cash deposits toward underperforming segments to return them to their target weight.
Redirecting Investment Income: Instead of automatically reinvesting dividends and interest, investors can let investment income pool up and use it to buy underweighted segments.
Strategic Withdrawals: When an investor needs to pull cash from their portfolio, they can choose to fund those withdrawals by selectively selling off the overperforming segments.
Asset Location: By holding highly volatile segments in tax-advantaged accounts, investors can often rebalance the overall portfolio without triggering immediate tax consequences.
Tax-Loss Harvesting: Investors can offset the capital gains generated from selling winners by strategically selling losing positions elsewhere in their portfolio to harvest capital losses.
Charitable Donations: Investors can donate highly appreciated, overweighted assets directly to a charity, allowing them to trim their winners without paying capital gains taxes on the growth.
While systematic rebalancing is a powerful tool for enhancing long-term returns, it cannot be executed in a vacuum. Effective rebalancing needs to incorporate tax awareness to ensure that the rebalancing premium isn't entirely surrendered to the IRS. Because Palisade focuses heavily on minimizing taxes, we employ all of the strategies above to minimize the taxes from systematic rebalancing.
