Many robo advisors offer an automatic rebalancing feature. Passive investors are not necessarily obligated to any generic rebalancing. You have the liberty to choose your account settings and thus personalize your asset allocation and complete portfolio management.
Robo advisors rebalance per the preselected settings for an account. Passive investors can choose the automatic rebalancing criteria based on portfolio preference, asset allocation, risk mitigation, cash flow, and tax minimization. You can also disable the auto rebalancing feature, if necessary.
In essence, robo advisors don’t have a fixed rebalancing routine. Changes are dictated by a client’s specific targets, real-time portfolio assessment including all assets under management, and the market dynamics, of course. Read on to know everything about how robo advisors rebalance.
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Table of Contents
When Do Robo Advisors Rebalance?
Robo advisors may rebalance as frequently or rarely as necessary. If your portfolio and all assets under management perform as expected and desired, there is no need to rebalance anything.
Hence, they conduct routine assessments per their algorithms and your chosen settings.
A robo advisor initiates the rebalancing process whenever the system detects a deviation, anomaly, or aberration in an individual portfolio or any of the assets allocated.
Such deviations, which serve as triggers, are defined using two sets of criteria. The first set of parameters is determined algorithmically based on the policies of the asset management company. The second set of decisive factors is based on your selections.
Therefore, in general, robo advisors rebalance when there is a need to:
- Undo asset allocation mismatch.
- Reduce high portfolio drift.
- Manage cash inflows.
- Reduce portfolio risk.
- Minimize tax liability.
- Adapt to client-initiated preferences.
Let’s discuss each situation in more detail.
6 Reasons Why Robo Advisors Rebalance
Asset Allocation Mismatch
Most robo advisors allow you to set your asset allocation preferences.
A robo advisor will initiate an automatic rebalance if the current state of your assets does not match the preferred allocation. Consider the following example:
- You decide to split your total asset allocation into 70:30 for stocks and bonds, respectively.
- The real-time proportion may or may not be the same as your predetermined 70:30.
- Robo advisors rebalance when an asset takes up a more or less share per the preset allocation.
If stocks form 80% of your total asset allocation in this example instead of 70%, your robo advisor will rebalance the portfolio to restore your selected proportion. The same approach applies if bonds form more than 30%.
However, stocks are usually more volatile than bonds. Thus, most portfolios are rebalanced to reduce the proportion of stocks to maintain the asset allocation preference.
Portfolio Drift Correction
Portfolio drift is similar to asset allocation mismatch in many ways. The differences rest in the purview and how a robo advisor defines it.
Asset allocation mismatch can broadly apply to an entire portfolio or remain specific to a particular ETF based on the robo advisor’s algorithm and a client’s preferences.
Likewise, portfolio drift can focus on every asset type or class and the total allocation deviation factor. Consider the following example:
- You decide to invest 40% in US-based ETFs, 20% in international stocks, 20% in domestic bonds, and 20% in a commodity like gold.
- Now, the real-time proportion of these four asset types or classes may be 50%, 25%, 15%, and 10%, respectively.
- A robo advisor calculates the portfolio drift for these deviations, which is usually a cumulative or total proportional mismatch.
- Then, the robo advisor initiates automatic rebalancing to restore your selected 40% in US-based ETFs, 20% in international stocks, 20% in domestic bonds, and 20% in gold.
A robo advisor may enable clients to select a point or percentage to trigger this rebalance when some portfolio drift occurs.
For instance, you may be comfortable with a total portfolio deviation of 5%. You can choose such a setting, if available. Your robo advisor will not rebalance until the total portfolio deviation or a particular asset allocation mismatch exceeds 5%.
Cash Flow Management
Cash flow management is essential in several circumstances. Buying and selling assets usually demand a rebalance. Asset reallocation, portfolio drift, changes in preferences or selected settings, and many such instances can trigger a rebalance to manage cash flow.
Robo advisors may buy an asset to counter a cash inflow or sell to neutralize a deficit in the net investment under management. In some cases, you may have to consider depositing some money to maintain the required cash or minimum account balance in your portfolio.
Also, cash flow management is necessary at times in the contexts of risk assessment & mitigation and tax-loss harvesting to minimize short-term capital gains and other immediate financial liabilities.
Portfolio Risk Mitigation
Robo advisors don’t have an identical approach to assess and mitigate risks. However, almost all robo advisors prioritize reducing the risk or financial vulnerability of a portfolio to nominal. Clients may choose to alter their exposure depending on their risk appetite.
Just as robo advisors correct asset allocation mismatch and high portfolio drift, the risks are assessed in real-time and mitigated whenever the exposure is untenable.
Bonds are usually deemed steadier than stocks. You naturally opt for low-risk investments if you prioritize bonds or commodities while personalizing your robo advisor portfolio.
Hence, the algorithm will trigger a rebalance whenever these investments are in the minority or disproportionately allocated.
Risk assessment is more complex than just comparing stocks and bonds. Algorithms study market dynamics and the performance of various funds, including stocks, bonds, and indexes. They also consider the volatility of specific assets across all classes within the ambit of the robo advisor.
An efficient robo advisor will rebalance whenever a particular portfolio is exposed to more risk than desirable. Exposure to volatile stocks is reduced. Safer or steadier investments are prioritized.
Such rebalancing happens whenever necessary, but only if this automatic function is active in your account.
Tax Minimization
Short-term capital gains incur higher taxes than long-term returns on investment. If you choose to activate tax-loss harvesting, your robo advisor will wait for a trade’s proceeds to become a long-term capital gain before executing it.
Likewise, suppose there is a cash inflow through dividends or other reallocations. In that case, a robo advisor may buy an asset to reduce or altogether avoid any short-term capital gain tax liability. This action needs automatic rebalancing.
However, there’s no preconceived action without considering the real-time factors.
For instance, if a sell option is deferred to avoid immediate tax liability, the same trade isn’t automatically executed when the return becomes a long-term capital gain. The sell option isn’t executed if it is no longer viable or profitable.
Rebalancing Necessitated by Clients
Robo advisors will rebalance whenever you initiate any change. You may change asset allocation, tax-loss harvesting, or any other customizable functions. The algorithms are usually programmed to respond to such changes immediately.
You may change the proportion or weighting of a particular asset class. You might want to increase or decrease the portfolio drift permissible in your portfolio management if such an option is available with your robo advisor.
Any significant alteration in your portfolio management, asset allocation, risk mitigation, and tax minimization settings will trigger an automatic rebalance, but only if such a function is active.
Automatic Rebalancing: Theory vs. Practice
You are likely to come across many robo advisors offering automatic rebalancing. The real test is how efficiently and effectively an algorithm rebalances.
Some robo advisors conduct daily assessments and rebalance if necessary. Others may not be so proactive. Exercise diligence when you compare such critical automatic functions.
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Conclusion
Rebalancing is fundamental to automate a robo advisor’s functioning. Also, automatic rebalancing is crucial for hands-off passive investing. A timely rebalance can prevent losses, reduce or eliminate unwarranted exposure and risks, and increase the net return on investment.
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