Why rebalancing is necessary
Over time, the value of individual ETFs in a diversified portfolio move up and down, drifting away from their target weights. For example, over the long term, stocks generally rise faster than bonds, so the stock portion of your portfolio will go up relative to the bond portion - if you don’t rebalance. The difference between the target weights for your portfolio and the actual weights in your current portfolio is called drift.
Measuring Portfolio Drift
We define portfolio drift as the total absolute deviation of each asset class from its target, divided by two. Here’s a simplified example, with only four assets:
|Total / 2||10%|
A high drift reduces the efficiency of your portfolio and may expose you to more (or less) risk than you intended when you set the target allocation.
Taking actions to reduce this drift is called rebalancing, which Betterment automatically does for you in several ways, depending on the circumstances, and always with an eye on tax efficiency.
Cash flow rebalancing
This method involves either buying or selling, but not both, and is preferable when cash flows into or out of the portfolio are happening anyway. Every cash flow (deposit, dividend reinvestment or withdrawal) is used to rebalance your portfolio. Fractional shares allow us to allocate these cash flows with precision to the penny.
Inflows: You are rebalanced whenever you make a deposit, including when you auto-deposit or receive dividends in your account. We use the inflow to buy the asset classes you are currently under-weight, reducing your drift. The result is that the need to sell in order to rebalance is reduced (and with sufficient inflows, eliminated completely). No sales means no capital gains, which means no taxes will be owed.
This method is so desirable that we’ve built it directly into your Portfolio tab. Whenever your drift is higher than normal (approximately 2% or higher), we calculate the deposit required to reduce your drift to zero, and make it easy for you to make the deposit.
Outflows: Outflows are likewise used to rebalance, by first selling asset classes which are overweight. (Once that is achieved, we sell all asset classes equally to keep you in balance.) We employ a sophisticated ‘lot selection’ algorithm called TaxMin within asset classes to minimize the tax impact as much as possible in taxable accounts.
In the absence of cash flows, we rebalance by selling and buying, reshuffling assets that are already in the portfolio. When cash flows are not sufficient to keep your portfolio’s drift within a certain tolerance, we sell just enough of the overweight asset classes, and use the proceeds to buy into the underweight asset classes to reduce the drift to zero.
Sell/Buy rebalancing is triggered whenever the portfolio drift reaches 3%. Our algorithms check your drift approximately once per day, and rebalance if necessary.
Note: In addition to the higher threshold, we built in another restriction into the rebalancing algorithm for taxable accounts. As with any sell trade, TaxMin selects the lowest tax impact lots, but stops before selling any lots that would realize short-term capital gains. Since short-term capital gains are taxed at a higher rate than long-term capital gains, we can achieve higher after-tax outcome by simply waiting for those lots to become long-term before rebalancing, if it’s still necessary at that point.
As a result, it’s possible for your portfolio to stay above the 3% drift if we have no long-term lots to sell. Almost always, it’s because the account is less than a year old. In this case, we recommend rebalancing via a deposit to avoid taxes. The Portfolio Tab will let you know how much to deposit, as described above.
Allocation Change Rebalancing
Rebalancing brings you back to your target allocation. Moving the slider in your goal does an allocation change, which changes that target. This sells securities and could possibly realize capital gains. Moreover, if you change your allocation even by 1%, you will be rebalanced entirely to match your new desired target allocation, regardless of tax consequences. As with all sell trades, we will utilize TaxMin to reduce the tax impact as much as possible.
If you’d like to turn off automated rebalancing so that Betterment only rebalances your portfolio in response to cash flows (i.e., deposits, withdrawals, or dividend reinvestments) and not by reshuffling assets already in the portfolio, please contact our customer support team - they will be happy to help you do this.