Trading, Monitoring, and Rebalancing Client Portfolios at Sherpa

Every financial planning client has a return requirement and a risk tolerance. When a prospective client meets with an advisor, the two outline what return is required from the client’s portfolio to meet the client’s goals and the level of risk which can be tolerated by the client. Once the return requirement and risk tolerance are determined, assets are then allocated in a manner which would generate that return while adhering to the clients risk tolerance.For example, the client and advisor may determine that the client’s assets should be allocated 40% to stocks and 60% to bonds. This 40/60 mix is the client’s strategic or long term asset allocation and it is an extremely important part of the client’s financial plan because a deviation from this allocation (caused by price changes in the portfolio’s holdings) could result in a level of return that is different from the one required to meet the client’s objectives, or cause the client to take on additional risk. For example, if the stock market has an exceptional year, then the price increases in stocks will cause stocks to have a heavier weight in the client’s portfolio compared to, say, bonds. And because stocks are typically riskier than bonds, this “drift” will unintentionally result in the client taking on more risk than they can tolerate. In order to avoid such asset class drifts, client portfolios must be efficiently monitored and rebalanced. But simply rebalancing without discipline or without the proper tools can be costly to the client because while rebalancing has benefits, it also generates costs to the client in the form taxes and transaction fees. Because rebalancing has a tradeoff between costs and benefits, a disciplined approach to rebalancing is an important aspect of a client’s financial plan. At Syverson Strege & Company and Sherpa Investment Management we have always employed a strict rebalancing rubric which has allowed us to adhere to our client’s stated risk/return mandates while also minimizing transaction fees and tax consequences. But with our recent move to TD Ameritrade and the new tools that we now have access to, our trading, monitoring and rebalancing processes have become much more efficient.

As I mentioned earlier, there are two types of costs associated with rebalancing a client’s portfolio: the transaction costs incurred as overweight assets are sold and underweight assets are bought; and the potential taxes generated when overweight securities are sold.  Without getting too technical, our move to TD has given us access to rebalancing software that relies on complex algorithms to rebalance client portfolios while minimizing the costs. With respect to transaction costs, these costs can be minimized by incorporating what are known as tolerance bands around funds that are held in client portfolios. For example, an equity fund may have a tolerance band of +/- 4%. This means that if the weight of the fund in the portfolio is supposed to be 20% it will only be rebalanced to its target weight of 20% if it’s weight exceeds 24% or falls below 16%; if, for example, the fund’s weight is at 21% it will not be rebalanced. This approach minimizes transaction costs because the portfolio is not traded every time the slightest deviation occurs. Our new software at TD not only allows us to incorporate such tolerance bands, but also allows us to customize these bands based on the characteristics of the asset class. For example, because stock prices fluctuate more than bond prices we can add wider tolerance bands for equity mutual funds than for bond funds and prevent triggering unnecessary rebalancing trades and transaction costs. With respect to the undesirable tax consequences of rebalancing a client portfolios, this new software is advanced enough that it orders trades in the most tax efficient manner every time we need to implement a rebalance. Specifically, every time funds need to be sold to implement a rebalance the software automatically orders funds with losses first (or the ones with the least gains) to minimize the tax impact.

In conclusion, trading, monitoring and rebalancing are important aspects of implementing a client’s financial plan. We have always payed close attention to these aspects of portfolio management because ignoring them could have negative impacts as far as risk and return are concerned. And with our move to TD Ameritrade our efficiency in this area has been magnified allowing us to serve our clients better.

- James Mantosh: