Why Rebalancing Is Necessary
Over time, the value of individual ETFs in a diversified portfolio moves up and down, drifting away from their target weights. For example, over the long term, stocks generally rise faster than bonds. The stock portion of your portfolio may go up in value faster 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.
Rebalancing is what corrects drift, bringing your portfolio back to its target allocation.
Measuring and defining "Drift"
We define ETF portfolio drift as the total absolute deviation of each super asset class from its target, divided by two. For Betterment constructed portfolios (excluding the Crypto ETF portfolio*), these “super” asset classes are US Bonds, International Bonds, Emerging Markets Bonds, US Stocks, International Stocks, and Emerging Markets Stocks. For custom portfolios designed by third-party Advisors, drift is calculated at the security group level, and Advisors can customize the drift tolerance thresholds for their client’s portfolio.
Here’s a simplified example using Betterment’s “super” asset classes, with only four assets:
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.
*Please note: As of the date of the publication of this article, Betterment’s default drift tolerance threshold is generally 3% for stock and bond ETF portfolios, 5% for portfolios containing mutual funds, 7% for Crypto ETF portfolios, and for custom model portfolios, Advisors can set a custom drift tolerance threshold. Betterment may change the default drift thresholds without notice.
Taking actions to reduce this drift is called rebalancing. Betterment seeks to rebalance your portfolio to reduce drift in several ways depending on the circumstances. Rebalancing requires a minimum portfolio balance (clients can review the estimated balance at www.betterment.com/legal/portfolio-minimum). The rebalancing algorithm is also calibrated to avoid frequent small rebalance transactions and to seek tax efficient outcomes, such as preventing wash sales and minimizing short-term capital gains. Our methods for rebalancing are:
- Cash Flow Rebalancing
- Sell/Buy Rebalancing
- Allocation Change Rebalancing
See here for details on each of these rebalancing methods, or review Betterment’s rebalancing disclosures.
*The Betterment Crypto ETF portfolio is composed of two ETFs that are market weighted in the portfolio, and as such, do not have geographic and stock to bond super asset classifications. See disclosures for more information.