Using ETFs to Rebalance Your Portfolio

No matter what’s in your portfolio, we believe it’s important to rebalance that portfolio periodically. That’s because when you put it together, you probably thought about how to combine your investments to make great rewards possible while making bad outcomes less likely.

But then the market happened. Some investments probably grew. Some investments probably shrank. And some investments probably muddled along without doing much at all.

That means the balance of risk and reward you set up at the beginning might be skewed. Maybe a stock has grown and is now, frankly, too much of your portfolio for comfort. Maybe a sector dropped, but you believe it’s going to rebound and want more of it in your portfolio.

Whatever has happened, you now may need to sell some investments and buy some other investments in order to bring the risk and reward opportunities closer to the asset allocation you initially targeted. You may even want to explore tax-loss harvesting—where you sell off some investments at a loss to balance those you’re selling at a gain—to limit your tax obligations from the rebalancing process.

ETFs can be a good tool to use as you rebalance your portfolio. Let’s look at rebalancing in more detail, and how ETFs can help.

What is portfolio rebalancing? 

Many financial experts recommend establishing a target asset allocation when building an investment portfolio. It’s not just about one of your accounts, but about all of them together: including taxable investment accounts, retirement accounts like an IRA or 401(k), and any other account(s) you hold.

A target asset allocation can involve several different dimensions, including 1) asset classes (stocks, bonds, and/or cash), 2) market cap (large, small, and mid-cap), 3) style (growth v. value), 4) geography, and 5) sectors, among others. There are also alternative investment classes such as real estate, currencies, crypto and a host of others. 

We believe your asset allocation should reflect your risk tolerance, the timing of your financial goals (such as how long you have until retirement) and other factors, and should be reviewed regularly, but not too often—think quarterly at most.

When the composition of your portfolio diverges significantly from that asset allocation, it’s time to bring your portfolio back into balance.

Rebalancing can generally be done by either:

• Selling overweight positions and using the proceeds to buy positions in underweight asset classes, or
• Using new money to purchase shares in underweight positions and bring them up to where they need to be. 

In fact, you may end up doing both of these depending upon your situation.

Rebalancing a portfolio using ETFs

Whether your portfolio is made up entirely of ETFs or holds a mix of investment vehicles, ETFs can be a useful tool in the rebalancing process.

That’s because many ETFs are index funds, either based on market indices or proprietary indices, and each ETF generally represents a distinct asset class. Instead of buying shares of one company (or even a small handful) to bring an underweight position up, you could buy shares of an ETF that follows that particular asset class.

Doing so could help diversify your portfolio and potentially limit risk, because an individual stock might underperform even if the asset class as a whole is performing well. 

Even better, if you sold an investment at a loss and want to replace it with something else, buying an ETF could help you avoid wash-sale rule penalties.

The wash-sale rule and tax-loss harvesting

Tax-loss harvesting involves selling investments at a loss, often during the rebalancing process, to offset realized gains elsewhere in the portfolio.

The wash-sale rule says that you can’t sell an investment at a loss and then buy the same (or substantially identical) investment at the same time. In other words, you aren’t allowed to lower your tax bill and then benefit from the same security without a time gap. That gap? 61 days: the 30 days before the sale, the day of the sale, and the 30 days after the sale. You also can’t simply sell it in one account and buy it in another; the wash-sale rule includes all of your accounts including IRAs, 401(k)s and others.¹

ETFs can be very useful in avoiding the wash-sale rule. If you sell shares of an individual stock at a loss, for example, you could safely purchase shares of an ETF in the same asset class as the shares of the stock that you sold.

Even if you sold shares of an ETF, you could purchase another ETF in the same asset class as a replacement (if it follows a different index, for example). You have to be more careful about the "substantially identical" provision of the rule, but given the breadth of index ETFs these days, there will likely be replacement options that adhere to the rule.

Advantages of ETFs

In addition to being useful tools for rebalancing, ETFs have a lot of advantages as investments. They generally have low expenses, are tax-efficient, and can give you broad exposure to a specific asset class. ETFs can be powerful building blocks in a portfolio and can help simplify the rebalancing process to help you adhere to your target asset allocation over time.