Introduction to Cryptocurrency Portfolio Rebalancing
What is Rebalancing?
Over a given period of time, a portfolio’s ratio of assets will change due to those assets having varying returns on performance. Rebalancing refers to the process of periodically buying or selling assets within a portfolio to maintain a specific asset allocation (ratio of assets). Portfolio rebalancing is often employed as a low-cost management strategy for long-term investment funds.
Benefits of Rebalancing
The main purpose of incorporating a rebalancing strategy into a portfolio is to reduce or “reset” the risk incurred from changes in asset valuations within a portfolio. Over a period of time, assets within a portfolio will have different returns that change a portfolio’s overall asset allocation.
A rebalancing strategy sells off relatively over performing assets and buys into underperforming assets within an portfolio’s asset allocation. By employing a periodic rebalancing strategy, a portfolio’s original risk profile can be maintained regardless of market movement and volatility.
Making decisions ultimately comes down to deciding on the risk and reward potential of an asset. Any asset will have a degree of risk associated with it. A rebalancing strategy is able to periodically assess the change in risk within a portfolio and make the necessary changes to return to the desired target portfolio profile and risk level. The primary goal of rebalancing a portfolio is not to maximize returns, but to minimize the risk relative to a target asset allocation.
Costs of Rebalancing
While rebalancing is a popular strategy with index funds, there are associated costs with rebalancing a portfolio. Here are some costs to expect in a rebalancing event or transaction:
Taxes (if applicable)
- If rebalancing within taxable registrations, capital gains taxes may be due upon the sale if the asset sold has appreciated in value.
Transaction costs to execute and process the trades (Trading Fees)
- For individual assets and exchange-traded funds (ETFs), the costs are likely to include commissions and bid-ask spreads.
Time and labor costs to compute the rebalancing amount
- These costs are incurred from administrative costs and management fees, if a professional manager is hired.
It’s important to account for the impact that expenses and fees can have on a portfolio’s overall return. One should weigh the costs and benefits of various rebalancing settings to create a portfolio that best fits their philosophy and risk profile.
Types of Rebalancing Strategies
A rebalancing strategy measures risk and return relative to the performance of a target asset allocation (Leland, 1999; Pliska and Suzuki, 2004). The decisions that can ultimately determine whether a portfolio’s actual performance is in line with the portfolio’s target asset allocation include how frequently the portfolio is monitored; the degree of deviation from the target asset allocation that triggers a rebalancing event; and whether a portfolio is rebalanced to its target or to a close approximation of the target.
While complex indicators can be used to trigger rebalancing events, we will focus on the 3 commonly-used strategies used today: “time-only,” “threshold-only,” and “time-and-threshold” based rebalancing.
Strategy #1: ‘Time-only’
In a “Time-only” strategy, a portfolio is rebalanced at a predefined or fixed time interval—hourly, daily, monthly, quarterly, etc. The only component in this rebalancing strategy is time, and rebalance events are fixed and occur on specified dates.
Strategy #2: ‘Target threshold-only’
In a “threshold-only” strategy, a portfolio is rebalanced when a portfolio’s asset allocation reaches a certain threshold. Once the desired rebalancing threshold is achieved, the portfolio is rebalanced to maintain the original asset allocation ratios. The only variable in this rebalancing strategy to account for is the target threshold, or the amount of drift within a portfolio.
Since threshold rebalancing occurs only when a specific asset allocation has been achieved, there is no given frequency for threshold rebalancing. Low-threshold portfolios (ie. 1%) are likely to experience more rebalancing events than high-threshold portfolios.
Strategy #3: ‘Time-and-threshold’
In a “time-and-threshold” rebalancing strategy, portfolio is constructed to rebalance on a scheduled interval, but only if the portfolio’s asset allocation has drifted and achieves the desired rebalancing threshold (such as 1%, 5%, 10%).
For instance, let’s take an index fund which uses a quarterly rebalancing strategy with a 5% drift threshold. We reach the end of the fiscal quarter Q1 2019, and we find that the portfolio drifts 4%. Based on the fund’s rebalance triggers, the index will not rebalance since the overall drift of the portfolio did not reach 5% when evaluated at the end of the quarter.
Let’s evaluate our previous example (quarterly rebalancing/5% drift threshold) in a different scenario. Let’s say this time the index drifted by as much as 8% during the first quarter, but eventually settled at a 3% portfolio drift at the end of the quarter. Since the threshold requirement was not met during the rebalancing date, the index will not rebalance as the threshold must be met on the exact rebalance date, and not any intermediate time interval.
In short, time-and-threshold index rebalancing only occurs when BOTH conditions are met.
Rebalancing & Cryptocurrencies
The first decade of cryptocurrency markets has shown us that we are in the early stage of growth in a completely new asset class. Even though there has been a development boom in the blockchain and crypto space, cryptocurrencies as an asset class is still extremely early, with much room for maturation and adoption.
For those looking to allocate a portion of their portfolio to crypto, incorporating an index and rebalancing strategy to a crypto portfolio can help reduce risk incurred from the large market movements while still maintaining a degree of exposure to crypto.
Learn more about Crypto Automation Tools for rebalancing & much more.