Portfolio construction and risk budgeting - Rebalancing tran...

Learning Outcomes

This article explains how portfolio rebalancing, transaction costs, and turnover control interact within a risk-budgeting framework for CFA Level 2 candidates. It defines risk budgeting and rebalancing, and explains why portfolios drift from target allocations and how this drift can breach risk limits. It contrasts calendar-based and threshold-based rebalancing policies, highlighting their implications for trading frequency, turnover, and implementation shortfall. It analyzes explicit and implicit transaction costs, including commissions, bid–ask spreads, taxes, market impact, and slippage, and links these costs directly to rebalancing decisions. It examines how volatility, asset liquidity, and investor risk aversion affect optimal rebalancing frequency and the design of rebalancing bands. It details practical turnover-control techniques such as tolerance bands, proportional rebalancing, and cash-flow-based rebalancing, emphasizing how these approaches can reduce unnecessary trades while keeping risk exposures within budget. It also develops your ability to interpret and construct simple rebalancing algorithms, evaluate trade-offs between tighter risk control and lower implementation costs, and diagnose when a rebalancing policy may underestimate implementation shortfall.

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are expected to understand the interaction of risk budgeting, portfolio construction, and implementation, with a focus on the following syllabus points:

• Explaining how risk budgets translate into portfolio allocations and tracking error limits
• Comparing rebalancing methodologies, including their costs and turnover outcomes
• Assessing the effect of transaction costs on rebalancing decisions
• Constructing practical algorithms to minimize turnover and transaction costs in rebalancing
• Describing the trade-offs between risk control and implementation efficiency during rebalancing

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which factor will increase portfolio turnover when implementing regular rebalancing?
   1. Tighter risk budgets
   2. Higher transaction costs
   3. Less frequent rebalancing
   4. Lower volatility in asset prices

2. True or false? A calendar-based rebalancing approach will always result in lower transaction costs than threshold-based rebalancing.

3. What is the primary reason for controlling portfolio turnover during rebalancing?

4. Briefly explain why risk aversion affects rebalancing frequency.

Introduction

Setting an effective risk budget and rebalancing a portfolio are essential tasks for prudent portfolio construction. Risk budgeting allocates “risk capital” across asset classes or strategies, defining acceptable levels for metrics such as tracking error or active risk. To ensure risk remains within the budget, managers must rebalance portfolios as market movements cause asset weights to drift from their targets. However, excessive trading increases costs and slippage that can erode returns. This article explains how rebalancing, transaction costs, and turnover controls are coordinated to manage exposure and maintain efficiency.

Key Term: risk budgeting
The process of allocating permissible levels of risk across a portfolio, strategies, or managers to maintain target exposures within specified limits.

Key Term: rebalancing
The systematic process of realigning a portfolio's asset weights back to their targets after market movements or cash flows have caused them to drift.

REBALANCING STRATEGIES AND TRANSACTION COSTS

The Rationale for Rebalancing

Drift from target allocations is inevitable due to changing market prices or disparate returns across asset classes. Left unmanaged, such drifts can cause a portfolio to breach risk budgets or take on exposures inconsistent with investor objectives. Rebalancing restores the portfolio to its intended structure.

However, each trade incurs explicit transaction costs—such as commissions and bid-offer spreads—as well as implicit costs like market impact and slippage. High turnover (proportion of the portfolio traded) reduces net portfolio returns.

Key Term: transaction costs
The explicit and implicit expenses incurred when executing trades, including commissions, bid-ask spreads, taxes, slippage, and market impact.

Key Term: turnover
The proportion of a portfolio's total value traded during a period, usually expressed as a percentage of assets under management.

Approaches to Rebalancing

Managers select a rebalancing policy that controls both risk and cost. The two most common policies are:

• Calendar-based rebalancing: Trades occur at fixed intervals (e.g., monthly or quarterly) to restore positions to target weights.

• Threshold-based rebalancing: Trades are triggered only when asset weights move outside predefined bands around targets.

Calendar approaches are simple, but may cause unnecessary trading if allocations have not drifted far, or may delay action if large drifts occur between scheduled dates.

Threshold approaches are more responsive to market movements, potentially reducing unnecessary trades but possibly increasing turnover if asset volatility is high.

Why Control Turnover

Every trade consumes resources and incurs costs. Balancing the frequency and trigger for rebalancing against cost is a central part of portfolio implementation. Excessive turnover can erode returns and, for taxable investors, increase taxes. Thus, efficient rebalancing seeks to maintain risk exposures tightly within budget while minimizing trading costs.

Worked Example 1.1

A balanced fund targets 60% equities and 40% bonds, but after 6 months, equities have risen to 65% of portfolio value.

Should the manager rebalance immediately if trading costs are 0.25%, or wait until the next planned quarterly rebalance?

Answer:
If the portfolio's policy is calendar-based (quarterly rebalance), and the scheduled rebalance date is in 2 weeks, the manager may defer rebalancing. If risk controls require tighter tracking to target, or if asset allocation drift exceeds tolerance, immediate rebalancing may be justified despite costs. The cost of trading (0.25%) must be weighed against the risk of significant deviation from the target and any breach of risk limits.

Sources of Transaction Costs

Rebalancing costs vary by asset class and liquidity. Highly liquid assets (large-cap stocks, major government bonds) trade at low cost. Illiquid assets (e.g., small-caps, higher-yield bonds, some alternatives) can be costly to trade. Transaction costs are typically modelled as a function of trade size, market liquidity, volatility, and order urgency.

Tax considerations and market impact are also important for some investors, particularly where large orders could move prices or where realized capital gains are taxed.

Worked Example 1.2

A manager uses a threshold-based rebalancing policy with a 5% band around a 40% equity target. If equities rise to 46%, should the manager trade immediately? If trading would cost 0.5% of value, is it better to wait for a wider deviation?

Answer:
The policy triggers a rebalance once the deviation exceeds 5% (i.e., at 45%). At 46%, the policy requires trading back to target. However, if expected further movement is small and transaction costs are material, the manager may assess the tradeoff between strict tracking and incremental cost. Some may adjust the rebalance threshold to balance costs if volatility or costs increase.

Balancing Risk Control and Cost Efficiency

The skill in portfolio implementation lies in balancing the desire for tight risk control (i.e., small permissible drift from targets) with the costs of trading to reset positions. More frequent or tighter-band rebalancing usually results in higher turnover. Conversely, wider bands or less frequent rebalancing reduces costs but may allow risk exposures to stray further from budgeted levels.

Managers also consider asset correlation and volatility: portfolios with more volatile or less correlated assets require more frequent rebalancing if tight risk control is desired.

Key Term: rebalancing band
The predetermined range around a target asset weight within which no rebalancing is required. Trading is triggered if the weight falls outside this range.

Rebalancing Algorithms and Turnover Control

To minimize unnecessary trades, managers may use:

• Tolerance bands: Delay trading until allocation drift breaches set thresholds.
• Proportional rebalancing: Trade only part of the way back toward target.
• Cash flow rebalancing: Use portfolio inflows or outflows to nudge allocations back toward target without selling existing assets.

Some strategies optimize rebalancing across the entire portfolio to minimize total costs, considering correlations among assets, transaction cost estimates, and active risk.

Worked Example 1.3

A multi-asset portfolio uses new monthly cash inflows to top up asset classes that have fallen below target, exhausting inflows before selling assets that are above target. If the inflow is less than required to re-establish all weights at target, how should the cash be allocated?

Answer:
Allocate incoming cash to the most underweight asset class first, then move up the list by degree of underweighting until the cash is exhausted. This minimizes trading and associated costs, while moving allocations as close as possible back toward target weights.

Exam Warning

Failing to account for both explicit and implicit transaction costs—or ignoring the impact of rebalancing frequency—can cause underestimation of implementation shortfall. Always analyze both sides of the risk/cost trade-off when justifying a rebalancing policy.

Summary

Maintaining portfolio risk within budget requires carefully designed rebalancing rules that control turnover and limit transaction costs. Calendar- and threshold-based rebalancing policies each have advantages and drawbacks. Transaction costs are unavoidable, but their impact can be minimized by thoughtful design of both rebalancing frequency and turnover control mechanisms. Efficient rebalancing preserves active risk limits and supports better long-term performance for both active and passive portfolios.

Key Point Checklist

This article has covered the following key knowledge points:

• How rebalancing keeps portfolios within risk budgets
• Influence of transaction costs on rebalancing decisions
• Impact of turnover on portfolio returns and risk management
• Major types of rebalancing policies (calendar-based, threshold-based)
• Methods for minimizing turnover and trading costs (tolerance bands, cash flow rebalancing)
• Trade-offs between risk exposure, rebalancing frequency, and implementation costs

Key Terms and Concepts

• risk budgeting
• rebalancing
• transaction costs
• turnover
• rebalancing band