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The Independent Adviser for Vanguard Investors
•
February 2016
•
15
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realized gains from trades. But these are
both key issues to consider when think-
ing about a rebalancing strategy.
I have never seen an analysis of the
tax cost of rebalancing, but I have tried
to roughly calculate what it might look
like for Vanguard’s latest recommen-
dation for taxable investors—annual
rebalancing with a 5% threshold. I ran
through the same analysis above, but
this time assumed no tax consequence
when selling bonds to buy stocks, while
counting each dollar sold when selling
stocks to buy bonds as a capital gain. I
then applied a flat 20% tax rate to those
capital gains. (Note: I assumed no tax
consequence when selling bonds to
keep this a conservative estimate and
because, when calculating cost basis,
bond funds rarely have large capital
gains after you’ve reinvested income
distributions.) The chart to the right
shows just how much of a cost taxes
can be when following a rebalanc-
ing strategy. This back-of-the-envelope
calculation of tax impacts reduced the
rebalanced portfolio’s growth rate by
about 45 bps per annum—which, as
you can see, really adds up over time.
Of course, there are other costs and
fees to consider besides taxes—so even if
you are investing in a retirement account,
you need to have your eyes open. For
instance, do funds in your portfolio have
front- or back-end loads or short-term
trading fees? Could you end up buying
into a fund just before it pays a distribu-
tion, or selling just after? (Many funds
still pay quarterly, and if you’re rebalanc-
ing in a taxable account, this could create
additional headaches.) Does your IRA,
401(k) or any other tax-free account have
limits on how frequently you can trade?
These are all questions you should be
asking yourself if you choose to develop
a rebalancing strategy.
One Strategy to RuleThemAll?
I know that I’ve argued throughout
this article that no single rebalancing
strategy is definitively superior to anoth-
er, but there might just be one method
that works best for taxable investors.
One of the simplest methods, and one
Dan has recommended for years, is
to make sure your funds pay distribu-
tions into a money market fund rather
than automatically reinvesting, and then
redirecting that cash to underweighted
funds. This does involve some work on
your part to actually reinvest those cash
distributions into the underweight funds
(though probably no more work than any
other rebalancing system), and, as we’ve
seen lately, you have to ensure Vanguard
is correctly following your instructions
when it comes to how they handle your
distributions, but this strategy can go a
long way to keeping your portfolio allo-
cation in check without having to sell
your winners to buy the losers.
Vanguard explored this rebalance-
through-distributions approach in the
whitepaper, and to my eye, it did just as
well as any other rebalancing strategy
that was reviewed—and almost cer-
tainly comes out ahead after taxes.
Of course, in all of these examples
we’ve assumed a starting portfolio that
never sees money flow in or out over
three decades, and, well, that just doesn’t
reflect reality—which opens up other
doors for rebalancing. If you are con-
tributing to a portfolio, you can make
new investments into the underallocated
funds in your portfolio. Or, if you’re at
the point where you’re drawing on the
portfolio for income, you might want to
make withdrawals from your winners to
reduce their allocation. (This, of course,
will generate its own tax bill, but you
can’t avoid taxes forever if you’re draw-
ing down your account.) These kinds of
moves will be the most effective in keep-
ing taxes and expenses down when com-
pared to making numerous mechanical
trades over the course of a year.
Remove Emotion From
the Equation
I mentioned this earlier and want to
repeat it. Emotions play a huge part in
rebalancing, and it’s that human factor
which often gets overlooked. It’s easy to
calmly discuss rebalancing a hypothetical
portfolio, as the press and Vanguard are
wont to do, but when it comes to reality,
many investors may find the idea coun-
terintuitive, as it requires you to reward
the losers in your portfolio with more
money while reducing your exposure to
the proven winners. And often it means
doing so at times of market tumult.
To take an extreme example, any
rebalancing strategy, and not just the
ones I mentioned above, would have
had you selling bonds to buy stocks
in 2008 and early 2009—a time when
many investors found it hard enough
to just stick with their investments at
all. To soften the example, if you have
a fund in your portfolio that’s been
Vanguard’s NewWay,
Not So Different
No Rebalancing
Annual Monitor w/5% Rebalancing
Semiannual w/5% Rebalancing
12/87
12/91
12/95
12/99
12/03
12/07
12/11
12/15
$0
$200
$400
$600
$800
$1,000
$1,200
Note: Combine calendar-based reviews with threshold rebalancing.
Costs Eat Away at
Rebalanced Portfolios
No Rebalancing
Annual Review w/5% Rebalancing w/Tax
Annual Review w/5% Rebalancing
12/87
12/91
12/95
12/99
12/03
12/07
12/11
12/15
$0
$200
$400
$600
$800
$1,000
$1,200
Still No Difference in Outcome
Trades
Terminal
Value of $100
Annualized
Return
Basis
Pt Diff.
MCL
No rebalancing
0
$1,067
8.50%
—
-34.5%
Annual w/5% Spread
18
$1,060
8.48% (2)
-25.1%
Semiannual w/5% Spread
23
$1,048
8.43% (7)
-25.9%
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