Thursday, October 7, 2010

Barriers to Portfolio Rebalancing

As my own investment portfolio has shifted from individual stocks to index ETFs, I've given more thought to portfolio rebalancing (see my earlier post on a rebalancing trap). I've discovered a number of barriers to the seemingly simple act of rebalancing a portfolio.
Life would be simpler if we had fewer accounts. Here are some common investment account types:

– Regular taxable
– RRSP
– Locked-in RRSP (withdrawn from a former employer's pension)
– Spousal RRSP
– TFSA
– RESP

For a couple there would be two of some of these accounts.

When there are so many accounts, rebalancing can become quite complex. What starts in theory as a single sell order and a single buy order may become multiple trades in practice.

We have reason to prefer holding certain assets inside or outside an RRSP for reasons such as taxes on interest or dividends. If rebalancing requires buying a particular asset, but the available cash is in the wrong account, then tax planning becomes more difficult.

Another complication is the desire to avoid selling investments in taxable accounts. If we can limit trading to within RRSPs, then we avoid paying capital gains.

However, trying to limit rebalancing trades to within RRSPs doesn’t solve all problems. If we have assets in U.S. dollars and have accounts with an institution that doesn’t permit U.S. dollars in RRSPs, trying to avoid excessive currency conversion costs can be challenging.

I have a spreadsheet that calculates when it makes sense to rebalance our family portfolio, but the problems I’ve mentioned have always complicated the process. It seems that it should be possible to develop a purely mechanical strategy that takes into account all relevant factors, but I'm not there yet.

6 comments:

  1. I've had the same problem for years. My approach to this has been to rebalance primarily by adding funds to whatever asset class is falling behind, as opposed to doing much selling. I realize, however, that this is not suitable for someone primarily withdrawing funds.

    As for US dollars, I believe Questrade allows one to hold US dollars in an RRSP and I know that TD Waterhouse can do "wash trades" involving a US-dollar money market fund, but it has to be done over the phone.

    ReplyDelete
  2. @Fernando: I suppose that someone primarily withdrawing funds could withdraw from whichever asset is over-valued. The main problem comes when the investor is neither adding nor withdrawing enough to maintain balance.

    The Royal Bank now allows investors to hold U.S. dollars in RRSPs and BMO Investorline has a system of allowing wash trades with an annoying phone call.

    ReplyDelete
  3. Yes, I have the same problems. Too many accounts with difference tax efficiencies and characteristics. My OCD compels me to choose the "optimal" move, I wish there'd be a calculator or program that can calculate it for me...

    As you mentioned, the primary problems are:

    1. currency conversion
    2. distribution tax (dividend, interest, roc)
    3. capital gain/loss
    4. foreign income
    5. assets that span more than one account
    6. trading commission

    ReplyDelete
  4. @Anonymous: You summarized the problems well. I have an automated spreadsheet that tells me when to rebalance taking into account commissions, spreads, and currency conversion, but it doesn't include various taxes or extra commissions from trading in multiple accounts. So, when my spreadsheet's flag goes up indicating that rebalancing makes sense, I still have to evaluate the situation manually. Too often my conclusion is that I can't efficiently rebalance.

    ReplyDelete
  5. How often do you really need to rebalance Michael? Maybe once or twice a year? Your thoughts?

    ReplyDelete
  6. @Financial Cents: It depends on many factors. Portfolio size, asset mix, tax situation, etc. In my case, it seems to come up every couple of months. But, my case is atypical.

    ReplyDelete