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One of our client facing presentations on rebalancing methods.

One of our client facing presentations on rebalancing methods.

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  • 1. Rebalancing Intelligently
  • 2. Topics What is Portfolio Rebalancing? Rebalancing Methods Costs & Considerations Benefits of Rebalancing A Part of our Holistic Approach
  • 3. What is Portfolio Rebalancing? A portfolio consists of multiple asset classes, and each asset class has a target allocation within the portfolio. Rebalancing involves trading in and out of asset classes that are “out of bounds.”
  • 4. Rebalancing Methods Tolerance-Band Rebalancing – A range around the target allocation in which the asset class can drift. For example, if the target is 10% with a 20% tolerance band, then the allowable range becomes 8% to 12%. Time Interval Rebalancing – Forces rebalancing on a strict schedule. (e.g., daily, weekly, monthly, quarterly, semi- annual, annual) Opportunistic Rebalancing – Employs tolerance band rebalancing with every cash flow event related to an account. Rebalancing decisions weigh the costs and benefits.
  • 5. Trading to Target: Tolerance Band Rebalancing Asset Class Target Actual Variance Action US Large 25% 10% -15% Buy US Small 10% 11% 1% No Change REIT 5% 6% 1% No Change Intl Large 25% 17% -8% Buy Intl Small 10% 16% 6% Sell US Bonds 13% 20% 8% Sell Global Bonds 13% 20% 8% Sell Total 100% 100% If the tolerance band is 20%, that means that the Target +/- (20% x Target) equals the tolerance range. Thus, a 10% target has a tolerance range of 8% to 12%. As long as the asset class is within this range, no trading in the asset class is necessary. This is a sample scenario, and all numbers are fictitious
  • 6. Tolerance Band Rebalancing This is the most common method used to rebalance a portfolio. below the tolerance band, then the underlying securities are being But within this method, there are many variables. What is the devalued. Investments into that asset class should be made to help tolerance band is the first question? If it’s too high, then there’s bring down the cost basis of that asset class. little reason to ever rebalance. If it’s too low, then the accounts This is a perpetual cycle within a portfolio. What is never known will be traded too much. is which asset class will over- or under-perform. By realizing gains and lowering cost basis through price-averaging, the Since the benefit of rebalancing is primarily to maintain the portfolio will benefit, and the client will benefit. A simple way of risk/return profile of the portfolio, which is critical to achieving looking at this is that realizing gains and then rebalancing, better long-term benchmarks, then a sound conclusion is that keeping a enables future gains as proceeds are used to purchase asset classes balanced portfolio is one of the best ways to realize goals. that are being devalued. A frequent question we receive is why not always trade to keep It is rarely such a simple example where one asset class is over the portfolio on target? First, the transaction costs would be and another is under. Typically, asset classes move quite astronomical at the end of the year and would greatly diminish randomly from one another, as such, a rebalancing scenario can any returns that were earned. Second, if the bands are too tight, become quite complex. Rather than keeping very tight control then growth is inhibited. and thus frequently rebalancing, it is best to provide some flexibility and allow classes to drift within reason. At the highest Asset classes will breach their upper and lower limits, which level, it is the fixed income to equity ratio that is the most means that asset classes grow and contract. When an asset class is important balance within a portfolio, and as a tolerance band is above it’s tolerance, that effectively means that the securities applied to individual asset classes, it may also be applied to the within that asset class have grown. Those gains should be fixed income to equity ratio. realized, and the portfolio should be manipulated to be brought back to target. By the same token, if an asset class is
  • 7. Interval Rebalancing in Practice Scheduled Scheduled Interval Interval Actual Allocations Rebalancing Actual Allocations Rebalancing Asset Classes Target Jan Feb Mar Action April May June Action July US Small 10% 11% 11.0% 16% Sell 10% 11% 9% Buy 10% US Small Value 10% 11% 11.0% 15% Sell 10% 10% 8% Buy 10% US Large 10% 8% 9.0% 7% Buy 10% 8% 11% Sell 10% US Large Value 10% 9% 9.0% 8% Buy 10% 9% 12% Sell 10% Intl Large 10% 8% 9.0% 14% Sell 10% 11% 11% Sell 10% Intl Large Value 10% 10% 10.0% 14% Sell 10% 11% 11% Sell 10% Short-Term FI 10% 12% 10.0% 7% Buy 10% 11% 9% Buy 10% Interm. FI 10% 10% 10.0% 5% Buy 10% 9% 12% Sell 10% TIPS 10% 11% 11.0% 9% Buy 10% 11% 9% Buy 10% Global Short FI 10% 10% 10.0% 5% Buy 10% 9% 8% Buy 10% Total: 100% 100% 100% 100% 100% 100% 100% 100% Trade Cost: Trade Cost: Equity to Fixed Income 60/40 57/43 58/42 74/26 $190 60/40 60/40 62/38 $190 60/40 Allocation: Hypothetical Standard 12% 11% 11% 18% 12% 12% 12% 12% Deviation: This is a sample scenario, and all numbers are fictitious
  • 8. Interval Rebalancing Interval rebalancing checks the need for rebalancing on a set The next example shows May and June as having the portfolio schedule. On one hand, this ensures that the portfolio is within the tolerance band. As July 1 is the date for scheduled monitored on a routine schedule, however, it implies forced interval rebalancing, the portfolio was traded to bring all of the trading. In other words, whether the portfolio needs to be asset classes back into balance. rebalanced or not, it will be rebalanced. This creates excess The benefit of this round of trading is questionable. As all of the trading, which eats away at returns by creating unnecessary classes were within 8% to 12%, a more thoughtful practice would trading fees. have been to continue to monitor the account, but not necessarily rebalance. Looking at the previous example, the portfolio became dangerously out of balance in between February and March. With In this scenario, the performance of the portfolio may actually a 10% target allocation, the tolerance range should be 8% to 12%, have been diminished as the asset classes were not allowed to which is +/- 20% of the target allocation. This is a generally grow and contract, and the natural return premiums were not accepted practice across firms that provide tolerance band allowed to be realized more fully. rebalancing. In March, we can see that 8 out of 10 asset classes Ultimately, this shows us that the routine monitoring of interval were out of tolerance. rebalancing is very helpful, but blindly rebalancing is not an appropriate course of action. Rather, it would be more beneficial Since the interval rebalancing, in this case, is being done to monitor regularly and rebalance when the benefit outweighs quarterly, the portfolio was caught in April and rebalanced. Had the costs. the portfolio manager been more flexible, the portfolio could have been corrected in March and the account would not have sat in an undesirable risk/return profile for an entire month. Nonetheless, it is good that the rebalancing routine at least caught the shift in portfolio allocation.
  • 9. Opportunistic Rebalancing At a 10% Target, the allowable range is 8% to 12% ($10,000) $100,000 Cash Flows Events: Request Deposit Asset Classes Target 5-Jan Action 7-Jan 12-Feb Action 14-Feb US Small 10% 11% 11.1% 12% 11% US Small Value 10% 11% 11.1% 12% 11.0% US Large 10% 8% 8.1% 11% 10.0% US Large Value 10% 9% 9.1% 11% 10% Intl Large 10% 8% 8.1% 11% 10% Intl Large Value 10% 10% 10.1% 11% 10% Short-Term FI Interm. FI 10% 12% Sell 11.0% 8.0% Buy 9.0% Interm. FI 10% 10% 10.1% 8.0% Buy 9% TIPS 10% 11% 11.2% 9% Buy 10% Global Short FI 10% 10% 10.1% 7% Buy 10% Total: 100% 100% 100% 100.0% 100% Equity to Fixed 60/40 57/43 58/42 76/24 62/38 Income Allocation: This is a sample scenario, and all numbers are fictitious
  • 10. Opportunistic Rebalancing Opportunistic rebalancing assess the need to fully rebalance a In the second example, the portfolio is a rebalancing candidate as portfolio with every cash event, as well as on a routine schedule. the contribution of cash is substantial. After reviewing the The goal is to ensure that trading costs are minimized and that our situation, however, we see that equity classes are over the target, investment philosophy is being implemented successfully. In but still within the tolerance band. Thus equity could be sold, but some cases, a full rebalancing can be avoided. it is not vital. In the first example, a request for $10,000 was made on January By only investing in fixed income, the equity classes allocations 5th. The portfolio is reviewed and we see that Short Term Fixed are reduced. Ultimately, the portfolio is brought closer to target, income is over the target by 2%. This is an acceptable allocation, and perhaps more importantly, it is done so more quickly. Had no but because it is the most over the target, this class is a candidate cash events taken place, the account would still have been to be sold. In addition to the allocation, the amount of gains and monitored for changes in the allocation. This approach is an ideal losses needs to be considered in order to attempt to minimize tax blend of rebalancing strategies. liabilities. The system and methodologies that we use to monitor accounts allows us to take proactive measures, and helps ensure that, from a logistical perspective, a portfolio of accounts is being properly managed.
  • 11. Costs & Considerations of Rebalancing For a single order, the transaction cost should be kept less than 2% of the order value. Capital gains have to be considered, as creating too much tax liability is typically not ideal. Allowing asset classes to drift outside of the tolerance band fundamentally alters the risk/return profile of the portfolio. Rebalancing too often can limit portfolio growth, while the same is true if rebalancing is done too infrequently.
  • 12. Benefits of Rebalancing Maintains the integrity of the risk-return profile of the portfolio, thus better enabling personal benchmarks to be achieved. Improves monitoring of tax liabilities as a result of capital gains and losses. Captures gains when classes are performing well. Reduces cost basis when classes underperform, by dollar- cost averaging into those asset classes.
  • 13. A Part of our Holistic Approach Through our routine monitoring of portfolios, we are able to be more proactive in managing accounts. By wrapping rebalancing services into account needs, such as deposits, distributions, fees, or tax-loss harvesting, we accomplish more with your transaction cost dollars. Your long-term goals are our regular concern. Our intelligent rebalancing is constructed from disciplined guidelines and processes developed through 25 years of experience and deep belief in our investment philosophy.
  • 14. Disclosure THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION ON THIS PRESENTATION. THESE PERFORMANCE FIGURES ARE FOR INFORMATION PURPOSES ONLY AND DO NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY A SECURITY. THE RETURNS REPRESENT HYPOTHETICAL RESULTS OF AN INVESTMENT IN VARIOUS INDICES. IN STRUCTURING PORTFOLIOS FOR CLIENTS, MAMC WOULD NOT BE SELECTING THE SPECIFIC ASSET CLASS INDICES, BUT RATHER CERTAIN MUTUAL FUND SECURITIES THAT ATTEMPT TO TRACK THOSE INDICES. THEREFORE, THE RETURNS DO NOT REFLECT ACTUAL INVESTMENTS OF MONEY IN ANY MAMC PORTFOLIO, AND MAY NOT REFLECT THE IMPACT THAT MATERIAL ECONOMIC FACTORS MIGHT HAVE ON MAMC’S MANAGEMENT OF THE PORTFOLIOS IF IT WERE ACTUALLY MANAGING THE PORTFOLIOS DURING THE PERIOD DESCRIBED. PAST PERFORMANCE IS NOT INDICAITVE OF FUTURE RESULTS. NO INVESTOR HAS ACHIEVED THE EXACT PERFORMANCE RESULTS PRESENTED. IN ADDITION, RETURNS ARE BEFORE ADVISORY FEES, CUSTODIAL FEES, AND BROKERAGE COMMISSIONS. THE CLIENT’S RETURN WILL BE REDUCED BY THESE FEES AND EXPENSES. MORE INFORMATION ABOUT MAMC, ITS SERVICES, AND ITS INVESTMENT ADVISORY FEES IS CONTAINED IN THE FIRM’S ADV PART II. A COPY MAY BE OBTAINED BY CALLING THE NUMBER BELOW. For contact information please visit: www.mcleanfn.com or call (703) 827-0636. 14
  • 15. Disclosure We are registered nationally with the Securities and Exchange Commission. We provide investment information that we believe to be useful and accurate. However, there cannot be any guarantees. There are many different interpretations of investment statistics and many different ideas about how to best use them. None of these offer guarantees. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance. This presentation does not constitute a complete description of our investment services and is for informational purposes only. Past performance is no guarantee of future results or returns. The returns are generated per the retroactive application of a model, designed with the benefit of hindsight, to historical data (i.e., back-tested). They represent hypothetical results of an investment in various asset class indexes and do not reflect actual investments of money in any MAMC portfolio, and may not reflect the impact that material economic factors might have on MAMC’s management of the portfolios if it were actually managing the portfolios during the period described. Returns are gross of advisory fees, brokerage or other commissions, mutual fund exchange fees, and any other expenses that a client would have paid. The hypothetical results assume a yearly rebalancing of the portfolio and reinvestment of all dividends and distributions. The portfolios are not FDIC insured, and there can be no assurance that the portfolios will not decline in value. The S&P 500 Index, with which the hypothetical results of the portfolio have been compared, reflects investments in domestic equity securities. The MAMC portfolios invest in bonds, real estate, and international financial instruments, which are not reflected in the S&P 500. In addition, the equity securities comprising the S&P 500 may differ from the securities held in the portfolio. Information throughout this presentation, whether stock quotes, charts, articles, or any other statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission there of to the user. All investments involve risk, including foreign currency exchange rates, political risks, different methods of accounting and financial reporting, and foreign taxes. 15