What Is ETF Rebalancing? Benefits & Costs

ETF rebalancing can refer to a fund manager’s role in ensuring an ETF remains aligned with its investment objectives, such as tracking the performance of a benchmark index, or it can refer to an individual’s management of their ETF portfolio.  

In this article, we’ll touch on how ETFs rebalance their holdings, but we’ll focus more on how an investor can rebalance an ETF portfolio, why it’s important and common rebalancing mistakes to avoid. 

What Is ETF Rebalancing? 

ETF rebalancing refers to the process of adjusting the holdings of an ETF to maintain its desired asset allocation and investment strategy. Rebalancing may also refer to the process of adjusting the holdings in an investor’s ETF portfolio to maintain a specific asset allocation. Asset allocation refers to the percentage of a portfolio invested in different types of assets, such as stocks, bonds and cash.  

ETF rebalancing can refer to two primary types of rebalancing: 

• Index and ETF rebalancing 
• ETF portfolio rebalancing 

Index and ETF Rebalancing 

Most ETFs are designed to track a specific index, such as the S&P 500, and their holdings are adjusted to mirror the composition of the underlying index. For example, if the S&P 500 adds or removes a stock from the index, the ETF that tracks the index will do the same. Similarly, if the S&P 500 changes the allocation weights of holdings, the ETF will also change the weights of its holdings. 

ETF Portfolio Rebalancing 

An investor may rebalance their portfolio to return allocation weights to previously set targets. For example, let’s say an investor’s target asset allocation is 60% stocks and 40% bonds. If stocks perform well and bonds underperform, the asset allocation may shift to 70% stocks and 30% bonds. To rebalance the portfolio, the investor would sell an appropriate amount of stock ETFs and buy enough bond ETFs to bring the allocation back to the 60/40 allocation target. 

Benefits of ETF Rebalancing 

ETF portfolio rebalancing can be beneficial to an investor to maintain their investment objectives and risk profile. For example, rebalancing can help to avoid being overexposed to any one asset class, reducing the risk of significant losses during market downturns. Rebalancing can also help to improve a portfolio’s returns by buying low and selling high. 

When to Rebalance a Portfolio of ETFs 

The frequency of portfolio rebalancing can be impacted by several factors, including an investor’s goals, risk tolerance and the volatility of the market. More specifically, deciding when to rebalance a portfolio may depend on predetermined time intervals or on a certain degree of deviation from the target allocations.  

For example, if an investor sets a predetermined time to rebalance, it should be at least annually, although some investors may choose quarterly. However, if a portfolio experiences significant fluctuations, such as during a market downturn, an investor may need to rebalance more frequently.  

How to Rebalance a Portfolio of ETFs 

Rebalancing a portfolio of ETFs is relatively straightforward. The first step is to determine your current asset allocation and compare it to your target asset allocation. You can do this by reviewing your portfolio and calculating the percentage of your holdings that are invested in each asset class. If any imbalances are identified, an investor may begin the rebalancing process.  

The two primary ways to rebalance a portfolio of ETFs include: 

• Selling overweighted ETFs and buying underweighted ETFs 
• Using new contributions 

Selling Overweighted ETFs and Buying Underweighted ETFs 

If you have an ETF that has increased in value and now represents a larger percentage of your portfolio than you intended, you can sell some of those shares and use the proceeds to buy shares of an ETF that is underweighted in your portfolio. 

Using New Contributions 

If an investor is regularly contributing to their portfolio, they can use those contributions to rebalance the portfolio. For example, if the target asset allocation is 60% stocks and 40% bonds, but the portfolio is currently 70% stocks and 30% bonds, an investor can direct their new contributions to bonds until they achieve the desired asset allocation. 

The Costs of ETF Rebalancing 

When rebalancing a portfolio of ETFs, it's important to keep in mind any transaction costs associated with buying and selling shares, as well as the potential tax implications of selling ETFs. It's important to note that more frequent rebalancing may result in higher transaction costs and potentially higher tax costs.

ETF Transaction Costs 

Transaction costs are expenses incurred when buying or selling securities in your portfolio. These costs include brokerage fees, bid/ask spreads and any other costs associated with trading. When rebalancing your portfolio of ETFs, transaction costs will be incurred each time you sell or buy shares. 

The cost of rebalancing will depend on the size of your portfolio, the frequency of rebalancing and the trading costs associated with the ETFs in your portfolio. Typically, ETFs have lower trading costs compared to mutual funds, making them a popular choice for investors looking to rebalance their portfolios. 

Tax Implications 

For investors holding ETFs in a taxable brokerage account, rebalancing a portfolio may have tax implications. For example, if an investor sells shares of an ETF that has increased in value, the shares sold may be subject to capital gains taxes. However, if an investor sells shares of an ETF that have decreased in value, the realized losses may be able to offset capital gains from other ETFs. 

The tax rate will depend on several factors, including the investor's income and the length of time that they held the ETF 

Common Mistakes Made With ETF Rebalancing 

There are several common mistakes, such as not having a plan or ignoring tax consequences, that investors can make when rebalancing their portfolios. Fortunately, with awareness and some planning, these mistakes can be avoided. 

Here are common ETF rebalancing mistakes and how to avoid them: 

• Not having a plan: Investors need to have a clear understanding of their investment goals and risk tolerance. They need to develop a plan that outlines their desired asset allocation and the frequency of rebalancing. Without a plan, investors may be more likely to make impulsive decisions that can harm their portfolio's performance. 
• Rebalancing too often: This can lead to unnecessary transaction costs and tax consequences. Instead, investors should rebalance their portfolios based on their investment goals and risk tolerance. For many investors and for most market environments, annual rebalancing is sufficient. 
• Ignoring tax implications: If an investor sells an ETF at a gain, they may be subject to capital gains taxes. To avoid or minimize taxes, an investor may want to sell ETFs that have losses to offset gains from other ETFs in their portfolio.  
• Not considering the overall portfolio: Investors need to consider their entire portfolio of ETFs, not just the asset allocation, when rebalancing. It's important to consider how each investment fits into the overall portfolio and how rebalancing one investment will impact the portfolio as a whole. 

Bottom Line 

It's important for an investor to regularly rebalance their portfolio to ensure that it stays aligned with their investment goals and risk tolerance. By having a plan, rebalancing at the appropriate frequency, considering tax implications and considering the overall portfolio, investors can avoid common mistakes made with ETF rebalancing and maintain a well-diversified portfolio.