(PUB) Investing 2016

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Vanguard’s NewWay, Not So Different

Still No Difference in Outcome

Terminal Value of $100

Annualized Return

Basis Pt Diff.

$1,200

Trades

MCL

No Rebalancing Annual Monitor w/5% Rebalancing Semiannual w/5% Rebalancing

No rebalancing

$1,067 $1,060 $1,048

8.50%

—

-34.5% -25.1% -25.9%

$1,000

Annual w/5% Spread Semiannual w/5% Spread

18 23

8.48% (2) 8.43% (7)

$800

$600

401(k) or any other tax-free account have limits on how frequently you can trade? These are all questions you should be asking yourself if you choose to develop a rebalancing strategy. One Strategy to RuleThemAll? I know that I’ve argued throughout this article that no single rebalancing strategy is definitively superior to anoth- er, but there might just be one method that works best for taxable investors. One of the simplest methods, and one Dan has recommended for years, is to make sure your funds pay distribu- tions into a money market fund rather than automatically reinvesting, and then redirecting that cash to underweighted funds. This does involve some work on your part to actually reinvest those cash distributions into the underweight funds (though probably no more work than any other rebalancing system), and, as we’ve seen lately, you have to ensure Vanguard is correctly following your instructions when it comes to how they handle your distributions, but this strategy can go a long way to keeping your portfolio allo- cation in check without having to sell your winners to buy the losers. Vanguard explored this rebalance- through-distributions approach in the whitepaper, and to my eye, it did just as

well as any other rebalancing strategy that was reviewed—and almost cer- tainly comes out ahead after taxes. Of course, in all of these examples we’ve assumed a starting portfolio that never sees money flow in or out over three decades, and, well, that just doesn’t reflect reality—which opens up other doors for rebalancing. If you are con- tributing to a portfolio, you can make new investments into the underallocated funds in your portfolio. Or, if you’re at the point where you’re drawing on the portfolio for income, you might want to make withdrawals from your winners to reduce their allocation. (This, of course, will generate its own tax bill, but you can’t avoid taxes forever if you’re draw- ing down your account.) These kinds of moves will be the most effective in keep- ing taxes and expenses down when com- pared to making numerous mechanical trades over the course of a year. I mentioned this earlier and want to repeat it. Emotions play a huge part in rebalancing, and it’s that human factor which often gets overlooked. It’s easy to calmly discuss rebalancing a hypothetical portfolio, as the press and Vanguard are wont to do, but when it comes to reality, many investors may find the idea coun- terintuitive, as it requires you to reward the losers in your portfolio with more money while reducing your exposure to the proven winners. And often it means doing so at times of market tumult. To take an extreme example, any rebalancing strategy, and not just the ones I mentioned above, would have had you selling bonds to buy stocks in 2008 and early 2009—a time when many investors found it hard enough to just stick with their investments at all. To soften the example, if you have a fund in your portfolio that’s been > Remove Emotion From the Equation

$400

$200

12/87

12/91

12/95

12/99

12/03

12/07

12/11

12/15

Note: Combine calendar-based reviews with threshold rebalancing.

realized gains from trades. But these are both key issues to consider when think- ing about a rebalancing strategy. I have never seen an analysis of the tax cost of rebalancing, but I have tried to roughly calculate what it might look like for Vanguard’s latest recommen- dation for taxable investors—annual rebalancing with a 5% threshold. I ran through the same analysis above, but this time assumed no tax consequence when selling bonds to buy stocks, while counting each dollar sold when selling stocks to buy bonds as a capital gain. I then applied a flat 20% tax rate to those capital gains. (Note: I assumed no tax consequence when selling bonds to keep this a conservative estimate and because, when calculating cost basis, bond funds rarely have large capital gains after you’ve reinvested income distributions.) The chart to the right shows just how much of a cost taxes can be when following a rebalanc- ing strategy. This back-of-the-envelope calculation of tax impacts reduced the rebalanced portfolio’s growth rate by about 45 bps per annum—which, as you can see, really adds up over time. Of course, there are other costs and fees to consider besides taxes—so even if you are investing in a retirement account, you need to have your eyes open. For instance, do funds in your portfolio have front- or back-end loads or short-term trading fees? Could you end up buying into a fund just before it pays a distribu- tion, or selling just after? (Many funds still pay quarterly, and if you’re rebalanc- ing in a taxable account, this could create additional headaches.) Does your IRA,

Costs Eat Away at Rebalanced Portfolios