Mutual Funds vs. ETF Rebalancing

The value of securities held in mutual fund and exchange-traded fund (ETF) portfolios changes over time. This causes the fund’s original asset allocation to change. Rebalancing a mutual fund or ETF portfolio allows the fund manager to bring the asset allocation back to its original mix.

Asset allocation is the percentage of types of asset classes in which a mutual fund or ETF invests. For example, one fund could have an asset allocation of 30 percent bonds and 70 percent stocks. The asset allocation of a mutual fund or ETF is a reflection of the length of time you plan to invest in the fund and your risk tolerance to changing market conditions. Once you discuss these matters with your fund manager, she will allocate your assets accordingly.

Rebalancing a mutual fund portfolio becomes necessary when the weighted value of one asset class category is greater or less than the fund’s original allocation for that particular asset class. The values of asset classes fluctuate due to changing market conditions. When this occurs, it no longer reflects your investment risk tolerance. The fund manager rebalances your mutual fund and sets the asset allocation back to the original mix of investments to reflect your original risk tolerance.

ETFs are baskets of securities that trade like stocks and track an index or a market sector. The goal of a traditional ETF is to match the returns of its associated index or market sector. The goal of leveraged ETFs is to realize returns that may be double or triple those of the underlying index or market sector. Leveraged ETFs use borrowed money to increase returns. Leveraged ETF managers may rebalance portfolios daily to set them back to their original asset allocation. Traditional ETF managers rebalance mutual as needed or by the calendar, such as semi-annually or quarterly.

To illustrate rebalancing in an example, suppose you have $100 invested in a fund with an asset allocation of 60 percent equities and 40 percent bonds. In this case, $60 is invested in equities and $40 in bonds. The value of the equities held in the fund increases by 20 percent while the value of the bonds remains unchanged. The value of the fund’s equities is now $72, making the total value of the fund $112. The asset allocation has now changed to 64 percent equities ($72 / $112 = .64) and 36 percent bonds ($40 / $112). The fund manager may choose to rebalance the fund by selling equities and buying bonds until their values are back to the original asset allocation of 60 percent equities and 40 percent bonds.