Rebalancing Alternative Investments: When Is the Right Time?

Imagine your investment portfolio as a carefully balanced seesaw. On one side, you have traditional assets like stocks and bonds. On the other, you’re exploring the exciting world of alternative investments – things like real estate, private equity, hedge funds, or commodities. Just like a seesaw needs adjustments to stay balanced as weights shift, your portfolio, especially one with alternative assets, needs rebalancing to stay aligned with your financial goals and risk tolerance.

But when exactly should you consider rebalancing a portfolio that includes these less conventional assets? The answer isn’t as straightforward as setting a calendar reminder. Rebalancing alternative investments requires a more nuanced approach compared to traditional assets due to their unique characteristics.

Firstly, understand that the why of rebalancing remains the same: to control risk and potentially enhance returns. Over time, some asset classes will naturally outperform others, causing your portfolio’s initial asset allocation to drift. If your alternatives surge while your stocks lag, your portfolio might become overweight in alternatives, potentially increasing its overall risk. Rebalancing brings it back to your desired proportions.

However, alternative investments are often less liquid and have less frequent valuations than publicly traded stocks and bonds. This illiquidity means you can’t just easily buy or sell them at any moment like you might with a stock. Valuations, often done quarterly or even less frequently, can also be lagged and less precise than daily market prices. Therefore, rigid, calendar-based rebalancing (e.g., annually or semi-annually) may not be the most practical or effective strategy for alternatives. For instance, trying to rebalance private equity quarterly is usually impossible due to its inherent long-term, illiquid nature.

Instead of solely relying on time-based rebalancing, consider threshold-based rebalancing as a more suitable primary approach for portfolios with alternative assets. This involves setting acceptable percentage ranges for each asset class within your portfolio. For example, if your target allocation for real estate is 10%, you might set a rebalancing threshold of +/- 2%. If real estate grows to represent 12% of your portfolio, triggering the upper threshold, it signals a potential rebalancing opportunity. Conversely, if it drops to 8%, hitting the lower threshold, it might also prompt a review.

These thresholds should be wider for alternative investments than for traditional assets due to their less frequent valuation and liquidity constraints. For example, you might use a 5% threshold for stocks but a 2-3% threshold for real estate or private credit. The specific threshold will depend on the volatility and liquidity characteristics of each alternative asset type and your overall portfolio strategy.

Beyond thresholds, qualitative triggers should also prompt a rebalancing review. These are less about numbers and more about significant changes in your investment thesis, the market environment, or your personal circumstances. For example:

• Changes in the underlying alternative investment: If there are fundamental changes in the management, strategy, or performance of a specific alternative investment fund or direct investment, it might be time to reassess its role in your portfolio and potentially rebalance.
• Significant market shifts: Major economic changes, interest rate hikes, or shifts in sector outlook could impact the relative attractiveness of different asset classes, including alternatives. A significant downturn in public markets might make your alternative asset allocation proportionally larger, warranting a rebalance.
• Changes in your personal financial situation or goals: As you approach retirement or experience other life changes, your risk tolerance and investment objectives may evolve. This could necessitate a shift in your overall asset allocation, including your allocation to alternative investments, leading to rebalancing.

Rebalancing alternative assets isn’t always about immediate buying and selling. Due to liquidity issues, it might involve adjusting your allocation in future investments. For instance, if your private equity allocation is overweight, you might reduce your allocation to new private equity commitments in favor of other asset classes until your portfolio comes back into balance over time as existing investments mature and distributions are received.

In summary, rebalancing portfolios with alternative assets requires a flexible and thoughtful approach. While time-based reviews can be part of your process, threshold-based triggers and qualitative assessments related to market conditions and your personal circumstances are often more relevant and practical for guiding your rebalancing decisions in the world of alternative investments. The goal is to maintain your desired risk profile and stay aligned with your long-term financial objectives, adapting to the unique nature of these assets.