Many investors overlook the importance of rebalancing their portfolio of ETFs. But because of this, these investors are missing out on returns! Rebalancing is essential for a healthy ETF portfolio, and we explain why. We also show you how you can rebalance in practice, and the importance of deciding on a rebalancing strategy and sticking to it.
What is rebalancing?
When your portfolio contains multiple ETFs, they all develop differently. As a result, over time, the ETFs become distributed differently than originally desired. Rebalancing means selling and buying parts of the ETFs in your portfolio to return to the initial allocation.
For example, suppose you set up a passive portfolio, allocating 60% to a stock ETF and 40% to a bond ETF. Over time, if equities outperform bonds, your portfolio may end up with an allocation of 70% to the stock ETF and only 30% to the bond ETF. To rebalance, you sell a piece of your equity ETF and buy the bond ETF additionally, to return to your original 60/40 allocation.
Why you should rebalance your portfolio
There are several reasons why it's important to rebalance your portfolio from time to time:
- Rebalancing brings your portfolio back to the risk level matched to your financial goals
- Rebalancing leads to higher returns
- Rebalancing instils discipline
- Rebalancing is an opportunity to adjust for change
Rebalancing brings your portfolio back to the risk level matched to your financial goals
Say that the 60/40 portfolio in the example above, with 60% invested in a stock ETF and 40% in a bond ETF, is the right portfolio for you. It has an expected return that's high enough to reach your financial goals, and with a risk that matches the risk that you are willing to take.
Over time, there's a good chance it will eventually veer to a 70/30 allocation. After all, stock ETFs tend to grow faster than bond ETFs. But the 70/30 portfolio has a different return-risk profile: it has a higher expected return, but also carries a higher risk. Your portfolio no longer matches you and your needs. You need to rebalance.
Rebalancing leads to higher returns
When you rebalance your portfolio, you sell the ETFs that outperformed and buy more of the ETFs that haven't been doing well. So in essence, you sell high and buy low. And this leads to a higher return on your portfolio than when you don't rebalance. When we analyse the past performance of the 60/40 portfolio, we see that rebalancing every 3 years led to a 0.37% higher return per year compared to not rebalancing at all.
Rebalancing instils discipline
Regular rebalancing fosters a discipline that helps prevent emotionally-driven investment decisions. As we will see below, it's a systematic approach that can prevent you from making impulsive decisions based on market hype or panic.
Rebalancing is an opportunity to adjust for change
Sometimes, your financial situation, goals, or risk tolerance may change. Rebalancing provides an opportunity to re-evaluate and make necessary adjustments to your portfolio.
How often to rebalance
In general, it's better to rebalance less often than too often. Rebalancing yearly or every 2 years is a good guideline.
The two most common strategies for rebalancing are:
- Periodic rebalancing: You rebalance at fixed intervals, for instance every 6 months, or every year...
- Threshold-based rebalancing: You rebalance when one of the ETFs in your portfolio goes out of balance by a certain percentage, for instance 5%.
Prefer to rebalance less often
Rebalancing involves trades, and trading isn't free. Buying and selling ETFs incur costs in the form of broker fees and potentially taxes, depending on your local tax system. For example, Belgian ETF investors have to pay a transaction tax between 0.12% and 1.32% (TOB) for every purchase. So it's important to ensure that rebalancing does not become an excuse to over-trade. It's better to rebalance less often, and stick to the strategy you set up for yourself. If you decided to rebalance every 2 years, don't rebalance already after 6 months. This isn't always easy as the emotional human in us favours action over inaction!
How does age-based rebalancing work?
As you grow older and get closer to reaching your financial goals, the risk you can take reduces. A young person with a 30-year investment horizon can afford to take a lot of risk. But someone who retires in 5 years cannot, and must opt for a more conservative portfolio.
For this reason, the risk profile of your portfolio must shift as you get older. Concretely, whereas a young 20-year old's ideal portfolio may consist of 90% stocks and 10% bonds, they should perhaps be on a 60/40 portfolio by the time they reach 40 years old. Rebalancing then offers a moment to reflect on this, and adjust the risk profile of the portfolio if necessary.
Simulate rebalancing strategies for your portfolio
You can run rebalancing simulations for your portfolio in Backtest, the backtesting tool built for the European ETF investor. Just select the ETFs in your portfolio and you'll be able to see how it performed in the past under different rebalancing strategies (email us at [email protected] if you can't find your ETF!). Beware though, a certain rebalancing strategy being the best in the past does not necessarily mean it'll be the best in the future!
How to rebalance your portfolio
It's an easy process:
- Determine if you need to rebalance according to the strategy you decided upon.
- Calculate how much of each ETF you need to sell, and how much you need to buy.
- Execute the trades with your broker. To reduce fees, you can choose to combine the rebalancing with your periodic investment.
Assume we want to bring back our 70/30 portfolio back to a 60/40 allocation. We will then sell 10% of the stock ETF, and buy 10% of the bond ETF.
Introducing Curvo: your portfolio is rebalanced automatically
We built Curvo to simplify index investing. When you invest through the Curvo app, your investments are managed by NNEK, a Dutch investment firm. They are licensed by the Dutch regulator (AFM) and are under their strict supervision.
Through Curvo, your portfolio is automatically kept in balance for you. The investments follow a 5% threshold-based rebalancing strategy. And unlike rebalancing through a broker, the rebalancings are free and don't incur extra costs for you. Especially Belgian investors will be happy as the investments aren't liable for the transaction tax (TOB), so no taxes need to be paid when rebalancing!
You are also periodically asked for any changes in your financial situation, goals or investment horizon. That way, your portfolio can be adjusted and always be in line with you as you grow older and progress in your life.
Learn more about how Curvo works.
What you should do now
- If you haven't already, you should decide on a rebalancing strategy for your investments. You can't go wrong with rebalancing yearly or every 2 years. You can also use Backtest to simulate how various rebalancing strategies have performed in the past.
- Write those events somewhere in a calendar, so that you are reminded when it's time to rebalance. When you have the system set up, all you need to do is follow it!
- Re-assess the composition of your portfolio when something happened in your financial life: you received an inheritance, you got promoted, or you lost your job...
- Decide if you want to invest through a broker, where you're responsible for rebalancing, or through an app like Curvo where it's done for you.
Summary
We explained what rebalancing is, and why it's important to keep your portfolio of ETFs in balance. We discussed two common strategies for rebalancing, namely periodic rebalancing and threshold-based rebalancing. Using Backtest, you can simulate how these have performed in the past for your own portfolio. Finally, we saw how Curvo can simplify your investments by not having to worry about rebalancing.
Questions you may have
How many ETFs should be in my portfolio?
Portfolio construction varies by individual needs, but simplicity is best. Prefer fewer ETFs in your portfolio:
- Easier management and monitoring.
- Lower broker fees cause you'll need to make fewer transactions.
- Minimised chance of overlap, like having both MSCI World and S&P 500 ETFs in your portfolio, which doesn't enhance diversification.
How to build a portfolio of ETFs?
The first step is to seek clarity on your goals. For most people, a single ETF is not enough to constitute a balanced portfolio that will bring them success over the long term. You must choose the right mix of indices to build a portfolio that fits you and your goals.
During the second step, you should pick the ETFs that can implement your portfolio. Aspects like diversification, low cost and tax efficiency play a role there. By carefully considering these properties, you can build a well-rounded ETF portfolio that is tailored to your investment needs and objectives.