We share another extract from our Knowledge Center, answering questions on automated rebalancing. How automated is "automated" rebalancing? What types of firms adopt automated rebalancing? What does "rebalancing" really mean? and more.
Welcome back to Smartleaf’s new Knowledge Center. It’s a resource that seeks to answer questions on topics important to the industry and your business. Here we share an extract from the automated rebalancing section. Read our first extract on directing here.
For more, visit the full Knowledge Center.
1. What is automated rebalancing?
When we talk about an automated rebalancing solution, we mean a system that, well, automates rebalancing. Not an alerting system. Not a suggestion system. Rather, a system that proactively generates solutions in the form of actionable trades that improve the portfolio and meet requests, such as cash in or cash out. This seems obvious, but it’s worth emphasizing. The word “automation” is commonly used to describe pretty much any efficiency tool. Here, we’re using the term in its more literal sense.
That being said, “automation” does not mean no humans are involved. Stuff happens, such as delayed processing of corporate actions and consequent inaccurate holding records, that will require human intervention. And firms may want to take a second look at accounts where the system’s proposed trades are unusual—for example, a $10 million account with proposed turnover that exceeds 30%. These accounts are “exceptions,” but not in the sense of being accounts that need to be rebalanced; these are simply the accounts with trades that firms decide merit a review.
At a basic level, automated rebalancing has been around for decades. Think of a strategy made up of five mutual funds rebalanced back to target weight on the first of every quarter.
What’s new is the ability to automate highly customized, tax-managed accounts, including those with individual equities and legacy holdings. Not only can the rebalancing of these types of accounts be automated, we have reached the stage where machines can do it better than portfolio managers. This isn’t because portfolio managers don’t know how to tax manage; it’s because portfolio managers simply don’t have the time. Expert tax and risk management requires daily attention. That’s impractical for portfolio managers, but not for computers. For this reason, computers are better at tax and drift management, even for ultra high net worth (UHNW) accounts. Automated rebalancing is not just a mechanism to do things more efficiently. It is a mechanism for doing things better.
2. What does "rebalancing" really mean?
When most people think of a rebalancing system, they think of a system that “snaps to center”. That is, it simply suggests trades that get the holdings in a portfolio exactly back to their target weights – if the target weight of IBM is 3%, then the system would generate trades that get you there.
That is not what we mean here. A better phrase might be a “balancing” system – a system that continually balances the competing considerations of low tracking error, low taxes, low transaction costs and low churn. An automated rebalancing system is a smart decisioning system that takes multiple inputs and produces trades that balance multiple competing goals. They control risk, ensure compliance, generate tax alpha, manage transitions and implement customization.
Their purpose is to actively and quickly convert the intellectual capital of the firm into specific trades for each account in a way that adheres, every day, to each account’s customization and tax management preferences. Or, viewed the other way around, the aim is to convert each account’s customization and tax management preferences into specific trades that reflect the firm’s investment guidance.
3. How automated is "automated" rebalancing?
The term “automated” is used pretty loosely in the industry. Sometimes it means nothing at all — the rough equivalent of when a local pizza shop adds “World Famous” to their name. As a result of this confusion, we tend to have conversations like the following:
Q: How many staff would it take to rebalance a book of 100 accounts?
A: Two people (really one, but you need a backup).
Q: What about 1,000 accounts?
A: Two people.
Q: 10,000 accounts?
A: Two people.
Q: 100,000?
A: Two.
This gets people’s attention, but then, understandably, this leads to a bit of poking:
Q: Wait, what if the accounts are tax managed?
A: No difference. Tax management, including tax-sensitive transition, is automated.
Q: What if clients have custom asset allocations? Or custom product mixes?
A: No difference
Q: What if there are social or religious screens? Lots of cash-out requests? Tactical asset allocation change? Model swaps?
A: No difference
At this point, the idea becomes clear that “automated” means, well, automated.
4. What is the value of automated rebalancing compared to traditional rebalancing?
First, and not surprisingly, it’s more efficient and compliant. Your costs are lowered, and you have no capacity constraints. Even when markets become really volatile, like in the first half of 2022, you can stay on top of rebalancing.
Second, by making customization and tax management incrementally costless, it makes it possible to customize and tax optimize every account, no matter how small.
Third, you have more control over your portfolios. You are able to implement decisions of your investment policy committee quickly across all portfolios, no matter how personalized.
Finally, and perhaps most importantly, it lets your client-facing advisors spend more time with clients and prospects.
5. What types of firms adopt automated rebalancing?
The firms we deal with typically have concluded that performance-, trade- and product-oriented value propositions are in decline. They wish, instead, to lead with a value proposition founded on financial planning. Tax and customization are also important. Their aim is to be their clients’ “lifetime financial coach”. And to help achieve this goal, they wish to free the client-facing advisor from having to spend time rebalancing portfolios. To this end, they’ll centralize rebalancing, while bringing the customization and tax management they offer to a higher level. Some firms are going beyond centralization towards outsourcing. They do it to focus on their core competency, and as with centralization, to increase the levels of customization and tax they can offer their clients.
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