Rebalancing in a Volatile Quarter
A $250M balanced portfolio has a target of 60% equities / 40% bonds with a rebalancing band of ±5% absolute. Equities have fallen sharply; the portfolio is now 53% equities / 47% bonds. The CIO's rebalancing policy says: rebalance when a band is breached, using cash flows first, then trading. The portfolio has $6M of anticipated contributions over the next month and $4M of benefit payments. The bond sleeve is a core aggregate index fund; the equity sleeve is split between a passive index fund and two active managers. The CIO is worried about selling bonds at a loss to buy equities into a falling market, and asks whether to rebalance now, wait, or use cash flows.
1. Is the 53/47 allocation actually outside the policy band, and what does the policy require? Be precise about the arithmetic.
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Target is 60/40 with a ±5% absolute band. That means the equity band is 55% to 65%. Current equity weight is 53%, which is 2 percentage points below the lower bound of 55% - i.e., the band is breached by 2 points.
So the policy does require rebalancing. The CIO's discomfort is understandable but is not a policy input: the band exists precisely to force buying after declines, and the whole point of a pre-committed band is to remove the discretion that the CIO is now trying to exercise.
Required trade size: to get back to 60% of $250M = $150M equities, from 53% = $132.5M, requires buying $17.5M of equities (and selling $17.5M of bonds), or some combination with cash flows. Note the band breach is modest; the policy does not require jumping to the target, only back inside the band. Rebalancing to the edge (55%) would require buying only (0.55 − 0.53) × $250M = $5M. The policy should specify whether rebalancing restores the target or the band edge; absent that, restoring the target is the conventional reading, but the CIO should confirm the governing document.
2. How should the $6M contributions and $4M benefit payments be deployed, and what is the case for and against waiting for the market to stabilize?
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Use cash flows first - the policy says so, and it is the cheapest rebalancing tool.
- Net cash flow is +$2M ($6M in − $4M out). Direct the $6M contribution into equities and fund the $4M benefit payments from bonds (or from cash). That moves roughly $6M into equities and $4M out of bonds, improving the equity weight by about (6 + 4)/250 ≈ 4 points of relative shift - enough to bring 53% back toward 57%, inside the band, with zero trading costs.
- This is the textbook use of cash flows: it rebalances without realizing losses or paying spreads, and it does not require a market call.
Case against waiting: waiting is a market-timing decision the policy forbids. "Buying into a falling market" is the definition of contrarian rebalancing; the band was set knowing this would happen. The risk of waiting is that equities rebound before the plan rebalances, leaving the portfolio underweight and the plan having missed the recovery - the classic rebalancing failure.
Case for a partial step: if the CIO genuinely believes the band is too tight, the correct action is to change the policy (e.g., widen to ±7% or use relative bands), prospectively and with board approval - not to ignore it this quarter. Ad hoc suspension of the band is how rebalancing discipline dies.
Recommendation: deploy the $6M contribution to equities, fund the $4M from bonds, and if the residual is still below 55%, complete the rebalance to target with a trade. Do not wait.