Tuesday, September 29, 2020

Rebalancing When There are No Trading Fees

Index investors usually choose some target allocation percentages for the different asset classes of stocks and bonds in their portfolios.  As markets move, these percentages can wander, so investors need to make trades to get back to their target percentages, a process called rebalancing.  Long-time reader JC asked how rebalancing changes when there are no trading fees.

Younger people with smaller portfolios typically rebalance only when they add new money to their portfolios.  This can be as simple as buying more of whichever asset class is furthest below its target percentage.  Those with larger portfolios can’t always keep balanced with new money; sometimes they have to sell an ETF that’s been rising to buy another that’s fallen behind.  One way to do this is to rebalance based on the calendar, perhaps once per year.  With this approach, having no trading fees makes little difference in how investors rebalance.

More ambitious investors may try “threshold rebalancing,” which means rebalancing whenever asset classes get too far from their target percentages.  This is best done in some automated way, such as with a spreadsheet.  Doing a bunch of calculations by hand every day to see if rebalancing is necessary isn’t my idea of a fun way to live.  In fact, I’ve set up my spreadsheet to email me if I need to rebalance, so I don’t even have to look at the spreadsheet.

Earlier this year, I wrote a post and an associated paper describing a set of rules for choosing rebalancing thresholds.  It’s somewhat complicated, but once coded into a spreadsheet, the complexity is hidden.  However, this work assumes investors pay trading commissions.  What happens when there are no trading commissions?

The first thing to understand is that commissions aren’t the only trading costs.  Traders also have the implicit cost of the bid-ask spread.  If there is a 2-cent difference between the bid price and ask price on a stock or ETF, then, on average, trading costs 1 cent per share.  For large trades, spreads effectively become wider due to the market impact of these big transactions.  The definition of a “large trade” depends on the liquidity of the ETFs you own.

For investors with sub-million-dollar portfolios who stick to popular broad-market ETFs, spread costs can be quite low.  So, if you plug in zero for the commission cost in my formulas, rebalancing thresholds will be narrow, leading to lots of rebalancing trading.

To decide whether this is a good idea, imagine that your spreadsheet tells you to rebalance three times a day.  Right away it’s clear that your time has value.  You might find rebalancing exciting for a little while, but it would feel like a job quickly.  It’s clear that you need to place some value on your time.  Once you get good at rebalancing, perhaps $5 or $10 per trade makes sense.

Another concern with frequent trading is uncertainty in the prices you’re getting.  Markets today are very efficient, but with some markets selling trade data to high-frequency traders or selling the right to make the market for the trade, it’s hard for individual investors to know if they’re getting good prices down to the penny.  If you trade infrequently, this isn’t much of a concern, but these imperceptibly small losses to market sharks add up if you trade too often.  For this reason it makes sense to be conservative in choosing a value for the typical spread on your favourite ETFs to plug into my formulas.

When I did my original rebalancing analysis, I included a factor f, which we might as well call a fudge factor.  I decided that I didn’t want to rebalance unless the expected profit from rebalancing was at least 20 times the trading costs (commissions plus spreads).  In part this is to make sure that I get to keep most of the profits instead of losing them all to costs.  But other reasons to make this factor as high as 20 are to place some value on your time, and to handle some uncertainty in the trading prices you’re getting.

So, in my formulas, you could replace the commission c with c+v, where v is the value of your time for each of the required trades.  You could also choose spread values on the high side for safety.  Then you could reduce the profit factor f to, say, 10.  This wouldn’t make much difference in the original case I envisioned where trading commissions are about $10, but these changes give better threshold levels when commissions are zero.

Something else to keep in mind is that your thresholds are most likely to get triggered in volatile markets, such as the ones we had earlier this year.  During this volatility markets remained orderly, so I went ahead and rebalanced a few times.  But if bid-ask spreads ever get very large, it’s a sign that markets aren’t orderly, and you should be cautious about trading for any reason.

It might seem like a lot of work to understand and implement threshold rebalancing, but it has a positive side effect for me beyond capturing profits during market volatility.  I mechanically follow my spreadsheet’s orders when it tells me to rebalance.  This means buying stocks after they’ve crashed or selling stocks after they’ve been on a tear.  Many investors can’t bring themselves to rebalance at these times, but my spreadsheet’s daily reminders to rebalance are hard to ignore.

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