Provisions for Rebalancing
Rebalancing is the process of adjusting or returning a portfolio toward the target asset allocation specified in the investment policy. Rebalancing is important because it keeps the institution's asset allocation from straying too far from policy guidelines. An asset mix allowed to drift with market returns automatically ensures that the portfolio will be overweighted in an asset class at market peaks and underweighted at market lows-a formula for guaranteed under performance. Failure to rebalance also increases the portfolio's risk level. If an endowment has drifted from its asset-allocation targets and a major market event occurs, the portfolio could be exposed to more risk than anticipated.
Two major methods of rebalancing exist: the calendar-based method and the use of target ranges. The calendar-based method simply means that the asset classes are rebalanced back to their policy targets at prespecified points in time, most often quarter- or year-end. Securities are then bought and sold as necessary to bring each asset class back to its policy target.
The other major method of rebalancing depends on the creation and use of asset-allocation ranges. To implement this rebalancing strategy, the investment policy must specify the acceptable ranges around the target asset allocation. Rebalancing should then occur whenever the limits of any range are breached.
The most efficient way to rebalance is available when cash flows occur on a regular basis. Funds coming into or being taken from the endowment can be used to rebalance the portfolio. Rebalancing can be accomplished quite efficiently by adding incoming dollars to asset classes that are below their target weight and by removing spending dollars from overweighted asset classes.
- Does your institution's investment policy expressly state that rebalancing will occur when the asset classes go beyond their policy ranges?
- Is the methodology to be used for rebalancing stated in the policy?