How Automatic Rebalancing Powers Long-Term Performance

What is rebalancing?

Rebalancing is the process of buying or selling assets to return your portfolio to a target weighting. When one asset is outperforming the other, its weighting in the portfolio grows, potentially exposing the investor to more risk than they would like. Periodically, the portfolio will need to be rebalanced back to the target weightings, locking in gains and reinvesting into underperforming assets.

Why does it matter?

Rebalancing is important because over time, based on the returns of the specific assets held in the portfolio, the asset weightings will change, altering the risk profile of the portfolio of assets.

For example, let’s consider the DeFi Pulse Index ($DPI) from Index Coop. The current largest allocation within the index is Uniswap ($UNI) at approximately 25%. If Uniswap doubled in price due to some announcement or event while the other assets in the index remained flat, then its weighting would increase from 25% to about 40%. Because of this one move, the portfolio of assets is now significantly more concentrated than intended. If Uniswap subsequently underperforms the remaining bucket of assets, then the $DPI would also underperform relative to its stated goal.

How do Index Coop products handle rebalancing?

Index Coop products, including $DPI, $MVI, and $BED, all use Set Protocol’s infrastructure to automatically rebalance the portfolio of assets in line with their defined methodologies on a monthly basis. Unlike the traditional finance world where users’ Index Funds or ETFs are rebalanced by fund managers on behalf of their clients, in DeFi this process is done automatically using smart contracts.

The benefit of built-in rebalancing means that you can passively hold an Index Coop product knowing that the asset allocation methodology will be followed. Theoretically, this leads to better performance relative to a non-rebalancing portfolio, reduces the potential of being over-exposed to a single asset, and makes getting exposure to a crypto theme more accessible than ever. As an added benefit, gas costs for rebalancing are handled by Index Coop and Set, helping to maximize the end-user’s return.