Benefits of Rebalancing your Cryptocurrency Portfolio
What is Rebalancing?
Rebalancing is one of the most simple strategies employed by investors in the institutional financial market. Over the course of the last few decades, it has become a staple for many portfolios. Keeping the portfolio in check, rebalancing will buy or sell assets in order to reach a desired percent amount of a given asset.
Over a given period of time, a portfolio’s ratio of assets will change due to those assets having varying returns on performance. This means the portfolio will no longer be aligned with the desired percent allocation for each asset. Rebalancing therefore refers to the process of periodically buying or selling assets within a portfolio to maintain a specific asset allocation (ratio of assets). Portfolio rebalancing is often employed as a low-cost management strategy for long-term investment funds.
Learn more about rebalancing here.
Benefits of Rebalancing
The main purpose of incorporating a rebalancing strategy into a portfolio is to reduce or “reset” the risk incurred from changes in asset valuations within a portfolio. The continuous drift of asset prices and percent allocations in a portfolio means the portfolio will consistently maintain varying levels of risk.
A rebalancing strategy sells off assets which over performed during the last period, while purchases the assets which under performed during the last time period. By employing a periodic rebalancing strategy, a portfolio’s original risk profile can be maintained regardless of market movement and volatility.
Making decisions ultimately comes down to determining the acceptable level of risk you are willing to accept for the reward potential possible in any given portfolio. Each individual will sustain a degree of risk. Implementing a rebalancing strategy will provide a way for your portfolio to automatically assess the change in risk and make adjustments to return your portfolio to the originally desired level of risk. The primary goal of rebalancing a portfolio is not to maximize returns, but to minimize the risk relative to a target asset allocation.
While reducing risk may be the main benefits of rebalancing, our studies have provided a strong case for rebalancing historically also increasing returns. You can find one of these studies here.
Costs of Rebalancing
While rebalancing is a popular strategy with index funds, there are associated costs with rebalancing a portfolio. Here are some costs to expect in a rebalancing event or transaction:
If rebalancing within taxable registrations, capital gains taxes may be an important factor in determining the appropriate rebalancing frequency.
For individual assets and exchange-traded funds (ETFs), the costs are likely to include exchange commissions and bid-ask spreads.
Time and labor costs to compute the execution of the rebalance
These costs are incurred from administrative costs and management fees, if a professional manager is hired.
It’s important to account for the impact that expenses and fees can have on a portfolio’s overall return. One should weigh the costs and benefits of various rebalancing settings to create a portfolio that best fits their philosophy and risk profile.
Types of Rebalancing Strategies
A rebalancing strategy measures risk and return relative to the performance of a target asset allocation (Leland, 1999; Pliska and Suzuki, 2004). The decisions that can ultimately determine whether a portfolio’s actual performance is in line with the portfolio’s target asset allocation include how frequently the portfolio is monitored; the degree of deviation from the target asset allocation that triggers a rebalancing event; and whether a portfolio is rebalanced to its target or to a close approximation of the target.
While complex indicators can be used to trigger rebalancing events, we will focus on the 3 commonly-used strategies used today: “time-only,” “threshold-only,” and “time-and-threshold” based rebalancing.
Strategy #1: ‘Time-only’
In a “time-only” strategy, a portfolio is rebalanced at a predefined or fixed time interval—hourly, daily, monthly, quarterly, etc. The only component in this rebalancing strategy is time, and rebalance events are fixed and occur on specified dates.
An example of a time-only rebalancing strategy would be if you wished to rebalance on a 24-hour interval. This would mean that every day at the same time, you would execute a rebalance.
Strategy #2: ‘Threshold-only’
In a “threshold-only” strategy, a portfolio is rebalanced when an individual asset in the portfolio reaches an allocation percentages which is further away from the target allocations than the threshold. Once the desired rebalancing threshold is achieved, the entire portfolio is rebalanced to maintain the originally desired allocation ratios. The only variable in this rebalancing strategy to account for is the threshold, or the amount of allowable drift within a portfolio.
Since threshold rebalancing occurs only when a specific asset allocation has been achieved, there is no given frequency for threshold rebalancing. Low-threshold portfolios (ie. 1%) are likely to experience more rebalancing events than high-threshold portfolios.
As an example, imagine we have a portfolio with 5 assets which each have a target allocation of 20%. If we desired a threshold of 5% to trigger rebalances, this would mean if the current allocation of any asset exceeded 21% or dropped below 19% of the total portfolio value, then the entire portfolio will be rebalanced.
Learn more about threshold-only rebalancing here.
Strategy #3: ‘Time-and-threshold’
In a “time-and-threshold” rebalancing strategy, a portfolio is instructed to rebalance on a scheduled interval, but only if the portfolio’s asset allocation has drifted and achieves the desired rebalancing threshold (such as 1%, 5%, 10%).
For instance, let’s take an index fund which uses a quarterly rebalancing strategy with a 5% drift threshold. If we reached the end of the fiscal quarter Q1 2019, and we found that the largest drift in the portfolio for an individual asset was only 4%. Based on the fund’s rebalance triggers, the index will not rebalance since the drift for any given asset in the portfolio must exceed 5% when the portfolio is evaluated at the end of the quarter.
Let’s evaluate our previous example (quarterly rebalancing/5% drift threshold) in a different scenario. Let’s say an individual asset in the index drifted by 8% towards the beginning of the first quarter, but by the end of the quarter settled at an only 3% drift. Since the threshold requirement was not met on the rebalancing date, the index will not rebalance as the threshold must be met on the exact rebalance date, and not any intermediate time interval.
In short, time-and-threshold index rebalancing only occurs when BOTH conditions are met.
Note: In contrast to strategies which require both conditions to be met at the same time, there are also times when you may want to trigger a rebalance when either condition is met. That would mean the events don’t need to take place at the same time, but could happen independently to trigger a rebalance. This option won’t be discussed in detail here.
Rebalancing & Cryptocurrencies
Although we’ve already eclipse the first decade of cryptocurrency. We’ve still seen time and time again that the markets remain immature as this emerging asset class has experienced rapid growth. Even though there has been a development boom in the blockchain and crypto space, cryptocurrencies as an asset class is still extremely early, with much room for maturation and adoption.
For those looking to allocate a portion of their portfolio to crypto, incorporating an index and rebalancing strategy to a crypto portfolio can help reduce risk incurred from the large market movements while still maintaining a degree of exposure to crypto.
Learn how to set up your own Crypto Index Fund with Shrimpy here.
Shrimpy leads the market as the premier portfolio rebalancing application. Users are able to configure a custom cryptocurrency portfolio and implement a passive rebalancing strategy, removing the hassle of having to actively trade crypto.
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