Balancing act: Enhancing target-date fund efficiency

Those are the findings in our new research paper, The Rebalancing Edge: Optimizing Target-Date Fund Rebalancing Through Threshold-Based Strategies.

TDFs are professionally managed multiasset portfolios designed to provide retirement savers with a suitable amount of growth and defensive assets based on their time horizon, retirement goals, and other considerations. TDFs are widely adopted in employer-sponsored 401(k) plans as well as IRAs.

The primary function of portfolio rebalancing is to keep portfolio risk in alignment with the fund’s target risk exposure. Without rebalancing, portfolio allocations drift from their intended target over time, particularly as the returns of underlying asset classes—equities and fixed income investments, for example—diverge.

Two approaches to portfolio rebalancing are most common in the TDF industry:

• With the more widespread calendar-based approach, portfolios are reset back to their target allocation at predetermined intervals, usually monthly or quarterly, no matter how much drift has occurred. This method is easy to implement, but can be susceptible to periods of heightened volatility, which can lead to large allocation drifts. Calendar-based rebalancing may also require larger trades, leading to higher transaction costs.
• Instead of sticking to a rigid schedule, portfolios with a threshold-based approach are monitored daily and rebalanced when the asset allocation drifts from its target by a predetermined threshold, such as 100 or 200 bps. This approach allows allocations to drift within guardrails, keeping the portfolio on track while helping to enhance returns by reducing transaction costs and avoiding unnecessary trades.

“In certain markets, like the one we experienced just after the onset of COVID-19, the potential portfolio variance between rebalancing methods can be drastic,” said Yu Zhang, Ph.D., a Vanguard investment strategist and lead author of the paper. “Through our research, we found the 200/175 policy preferable because it balances the trade-off between transaction costs and allocation drift, ultimately providing better risk control and potential investment outcomes.”

Our TDF rebalancing policy seeks to provide investors with the best chance for long-term investment success. To achieve this goal, we aim to lower transaction costs, which are a drag on returns, and limit the risk from large allocation drifts between rebalancing events.

Our research shows a threshold of 200 bps is suitable across different forecast models, while a destination of 175 bps leads to lower transaction costs when compared with other destinations. For a hypothetical 60% global equity/40% global fixed income portfolio over a 10-year period, Vanguard research shows that, when compared to calendar-based rebalancing strategies, the 200/175 threshold-based rebalancing method results in:

• Greater risk control. Allocation deviations are lower and better controlled when employing the 200/175 rebalancing method, which is expected to result in 43 bps less allocation deviation per year compared with monthly rebalancing and 135 bps less compared with quarterly rebalancing.
• Reduced transaction costs. The expected transaction costs are about 13–17 bps lower relative to quarterly and monthly approaches.
• Potentially higher relative returns. The 200/175 rebalancing policy results in relative returns that are potentially 11–18 bps higher per year than calendar-based approaches.

The overall benefit to TDF investors can be substantial. As part of the analysis, the authors measured the relative benefit of rebalancing approaches using the certainty fee equivalent, which can be interpreted as the fee an investor would be willing to pay for one rebalancing method over another.

“We found that, for a TDF investor, the annual relative benefit of 200/175 rebalancing can range from 5 to 21 bps when compared to calendar-based approaches,” said Zhang. “That advantage can add up to large sums over time, enhancing an investor’s best chance of investment success. Based on our analysis, the need for daily monitoring is well worth the potential for enhanced investment outcomes over the long term.”