Portfolio ManagementFebruary 9, 2017

    Over the course of 2016, financial markets saw some sizable moves downward as well as strong moves upward. Stocks began the year with a decline of more than 10%—a so-called market "correction"—and ended the year with a sharp rally and record highs. Likewise, interest rates fell significantly during the first half of 2016 and then rose sharply in the final months of the year.

    If you've invested through Schwab Intelligent Portfolios®, you may wonder what that volatility means for the asset allocation in your portfolio. As part of the program, portfolios are monitored daily for rebalancing purposes, and automatically rebalanced when asset class weightings drift too far from their targets—that is, when their size in the portfolio becomes either too large or too small, as can happen when a particular group of securities experiences a significant price increase or decline.

    A disciplined process for rebalancing your portfolio is important for keeping your level of risk consistent. Investments rise and fall in value as markets fluctuate, so rebalancing when asset classes drift too far from their targeted weighting ensures that your portfolio stays on track with your targeted level of risk.

    For example, if a portfolio consisting of 60% stocks and 40% bonds—as represented by the S&P 500® Index and the Bloomberg Barclays U.S. Aggregate Bond Index, respectively—had never been rebalanced during the 1990s, the allocation to stocks would have become a steadily larger percentage of the portfolio as stock prices soared during the decade. At the peak of the market, the portfolio would have had its largest weighting to stocks over that period—with a higher risk level than was intended—right before the bubble burst and stock prices tumbled. While rebalancing doesn’t eliminate volatility, it can help to reduce risk over time.

    How asset class volatility affects portfolio rebalancing

    So if an investment in your portfolio sees a sharp decline or rally, should you expect to see rebalancing trades? Possibly, but not necessarily. When considering rebalancing, it's important to recognize that the weighting of each asset class in your portfolio is determined not just by the price movement of that asset class but also by the price movement of every other asset class. In other words, a 10% decline or advance in stocks isn't enough information to know whether that move would trigger a rebalancing. We also would need to know how much price movement occurred in every other investment.

    Asset allocation is a balancing act. In the financial world—as in the physical one—nothing happens in a vacuum. Money that flows out of one area of the market must flow into another, which means there are a lot of moving parts to consider at any given time. To help illustrate how asset class price movement leads to changes in weightings and potential rebalancing, let's take a look at a simplified example.

    A rebalancing case study

    For this case study, we've put together a simple hypothetical portfolio (with an initial value of $50,000) consisting of four asset classes. Note that this does not represent any actual allocation made through Schwab Intelligent Portfolios, where each portfolio is broadly diversified and can comprise up to 20 individual asset classes, including cash:

    • U.S. stocks (30%)
    • International stocks (20%)
    • Emerging market stocks (10%)
    • Bonds (40%)

    Table 1 shows the initial hypothetical portfolio and the number of shares, price per share, dollar value and weighting of each asset class in the portfolio.

    Table 1: Initial portfolio and targeted asset class weightings
      Number of shares Price per share Value Weight
    U.S. stocks 300 $50 $15,000 30%
    International stocks 500 $20 $10,000 20%
    Emerging market stocks 200 $25 $5,000 10%
    Bonds 400 $50 $20,000 40%
    Total portfolio value - - $50,000 100%

    In Table 2, we consider how potential price movement in each of the four asset classes would change the weightings of each allocation and potentially result in a portfolio rebalancing.

    Table 2: Portfolio weightings after asset class price movement
      Number of shares Price move New price per share New value New weight Change in weight
    U.S. stocks 300 -5% $47.50 $14,250 28.9% -1.1%
    International stocks 500 -10% $18 $9,000 18.3% -1.7%
    Emerging markets stocks 200 -20% $20 $4,000 8.1% -1.9%
    Bonds 400 10% $55 $22,000 44.7% +4.7%
    Total portfolio value - - - $49,250 100%  

    As illustrated in Table 2, emerging market stocks had the biggest price move (-20%) but didn't drift as far from their targeted weighting as bonds, which had a smaller move (+10%). In this case, the change in weighting for bonds could trigger a rebalance in which bonds would be sold to bring the asset class back to its targeted weighting of 40%.

    Although other asset classes saw smaller weighting changes and might not have triggered a rebalance themselves, the proceeds from the sale of the bonds should be reinvested. This would be accomplished by iteratively buying shares of underweight asset classes, beginning with the most-underweight. In this example, emerging markets is the most underweight, so proceeds would first be used to buy enough shares to bring this asset class back as close as possible to its target weight. If proceeds remained after buying these shares, the algorithm would next buy international stocks because that is the next most-underweight asset class.

    Conclusion

    Schwab Intelligent Portfolios uses the power of technology along with human oversight to rebalance your portfolio as needed. In our simplified example, one asset class triggered a rebalance, but other asset classes also experienced rebalancing trades. The number of rebalancing trades will vary depending on the market environment, but the process is designed to keep your portfolio's risk profile consistent, while not overtrading based on slight deviations from targeted weights for each asset class.

    The broad diversification within Schwab Intelligent Portfolios—up to 20 asset classes in any portfolio—means that implementing this rebalancing process could be complex and challenging for an individual investor trying to manually manage his or her portfolio. This is one of the areas where the power of technology shines, by allowing us to simplify the portfolio management process and make important features like rebalancing more efficient.

    David Koenig, CFA, FRM, is Chief Investment Strategist at Schwab Wealth Investment Advisory, Inc.

    Cash balances held in the Sweep Program at Schwab Bank are eligible for FDIC insurance up to allowable limits.

    Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

    Schwab Intelligent Portfolios is designed to monitor a client's portfolio on a daily basis and will also automatically rebalance as needed to keep the portfolio consistent with the client's selected risk profile unless such rebalancing may not be in the best interest of the client. Trading may not take place daily.

    Investing involves risks including possible loss of principal.

    (0217-UBBG)


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