What prevents automated rebalancing from being infinitely scalable?
A “lights out” factory is one that is totally automated. There are no people, so there’s no reason to have the lights on. However, most automation isn’t totally automated. But why? Why not infinity?
We were recently asked this question about our rebalancing system. It’s automated, but, like any automated system, not infinitely so. What real-world limitations do we run into? It’s not simply that portfolio management is complex. The stuff that humans can find challenging—tax management, substitutions, transitions, social screens, trade-offs, asset class customization, product customization—can be automated relatively easily.
So why not infinity? There are multiple reasons:
The most common problem is bad data—unknown securities, late-processing of corporate actions, file transfer failures, etc. If you don’t have good data, your system won’t work. It’s easy enough to suspend affected accounts, but someone needs to get to the source of the problem and fix it. (See Bad Data and Automated Rebalancing.)
It’s not common, but it’s possible to get portfolios with impossible sets of requests. For example, a portfolio might get a “cash out” request that can’t be filled because too many of the portfolio positions are restricted. Or a “minimum asset class” weight that can’t be fulfilled because every security in that asset class has been blocked by an Environmental Social Governance (ESG) restriction (See Q&A: ESG Investing.)
This problem is declining as more processes and forms are fully digitized. But not everyone is there yet. So, you end up with portfolios that are suspended pending authorization of one sort or another. This can require running around (sometimes literally).
Suppose a client called and said they’re transferring in $1mm next week. It probably makes sense to suspend trading until the new cash infusion comes in.
Many advisors will suspend trading when individual securities or entire markets become unusually volatile.
Smaller accounts, even when highly customized and tax managed, are often “robo rebalanced”, traded in batch without review. On the other hand, every firm we work with will review trades of ultra high net worth accounts, say those over $25mm.This is not because they expect problems, but just because these are their most important accounts. For midsize accounts, firms will perform spot checks, reviewing trades that create unusually high turnover or tax incidence, or that leave portfolios with atypical drift.
With the exception of elective reviews — which take place at whatever frequency the firm desires — all of these special handling circumstances are rare. And, even when they arise, they rarely take much time to process. (See Automated Rebalancing Workflows that Work For You.) But when managing tens or hundreds of thousands of accounts, these exceptional events add up. In a practical and economic sense, it’s still highly scalable. But not infinite.