How To Rebalance Mutual Fund Portfolio In 2026: Complete Guide With Tax Implications And Best Practices
Direct and indirect retail holdings in India have increased more than 10 times over the last 10 years. As of January 2025, 17.6% of the total market capitalisation is held by retail investors.
Given the dynamic nature of the Indian markets, retail investors can optimise returns through successful portfolio management. Portfolio management not only includes the initial portfolio diversification but also subsequent monitoring and remedial measures. The subsequent aspect of portfolio management is integral to portfolio rebalancing.
Portfolio rebalancing is key to both direct (for example, stock) and indirect (for example, mutual funds) investments. This blog gives a detailed guide on how to rebalance a mutual fund portfolio.
What Is Portfolio Rebalancing?
Portfolio rebalancing is necessary to take corrective measures during a portfolio drift. However, before getting into the steps to rebalance a mutual fund portfolio, it is important to understand the meaning of portfolio rebalancing and portfolio drift.
Definition And Concept
The process of selling existing securities and purchasing new ones through periodic assessment to preserve the original asset allocation in mutual funds or to stay on track with investment goals and risk profiles is called portfolio rebalancing.
The market is dynamic, meaning that the market price of securities changes over time. It is necessary to review a portfolio to gauge the consistently poor performance of certain assets and take corrective measures.
For instance, Mr A owns 10 units of the ABC mutual fund and 5 units of the XYZ mutual fund. Mr A reviews his portfolio monthly and notices the following trend.
| Particulars | NAV in July (INR) | NAV in August (INR) | NAV in September (INR) |
| ABC | 250 | 220 | 150 |
| XYZ | 100 | 150 | 200 |
Given the sharp decline in the NAV of ABC units and the consistent growth of XYZ units, Mr A may decide to sell his ABC units. This assessment and resultant decision are called portfolio rebalancing.
Moreover during certain key events like marriage, emergency, etc., an investor might need to rebalance his portfolio. For instance, say Mr B is about to get married and he sells some underperforming units of his mutual fund portfolio to accumulate INR 30,00,000 for his expenses.
How Portfolio Drift Happens
Market fluctuations cause deviations between the intended market performance and the actual market performance of particular assets, resulting in a deviation in the overall intended performance of a portfolio.
For instance, Ms B anticipated the NAV of ABC mutual fund units to grow from INR 300 to INR 350. However, it fell to 280.
| Old NAV (INR) | New NAV (INR) | Growth (%) | |
| Expected case | 300 | 350 | 16.67 |
| Actual case | 300 | 280 | (6.67) |
The discrepancy between actual return and anticipated return due to market fluctuations is called portfolio drift. Therefore, it is important to rebalance a mutual fund portfolio to rectify portfolio drift.
Understanding Portfolio Drift With Real Examples
The term "portfolio drift" refers to the way in which an investment portfolio's initial asset allocation changes due to fluctuations in the stock market.
In this example, Ravi's portfolio originally consisted of 70% equities and 30% bonds. After he experienced a stock market bull run, Ravi's equity rose to 85% of his total portfolio, while Debt fell to 15%. The fact that Ravi now holds a disproportionately high amount of Equities compared to his Debt means that his overall portfolio balance has shifted. Consequently, Ravi's increased exposure to equities carries greater risk than he originally planned.
Similarly, in Priya's example, while her Debt position is holding steady, her Equities have decreased from 70% to 55%. In this situation, Priya's Debt position is now too low to allow for growth. Thus, both examples show how important it is to perform regular rebalances on an ongoing basis to help maintain a balanced mutual fund portfolio.
Step-By-Step Guide To Rebalance Your Portfolio
Rebalancing of mutual fund portfolios should follow a systematic method for restoring target allocation within those portfolios. To accomplish this requires reviewing current fund holdings with an emphasis on appropriate positions in accordance with the desired allocations (such as 60% equity/40% debt), buying and/or selling funds based upon your review and your original percentages.
The rebalancing of your portfolio will result in benefits throughout the investment cycle due to the methodical approach.
- Make an inventory of all the funds you hold and how much money you currently have in those funds.
- After this, you need to compare those holdings against the original allocations you intended to have (60% equity /40% debt).
- From your inventory of funds, you will identify the overweight positions that you want to reduce. You will also identify the underweight positions that you want to increase.
- After identifying these two categories of funds, execute all of your transactions in one trade to minimise costs.
In Ravi's situation, where the portfolio is overweighted at 85% equity, you will sell equity units to bring that position down to the appropriate level of 70% equity. You will then use the proceeds from the sale of the equity funds to purchase fixed-income funds to return the portfolio to 30% fixed-income.
After executing the trades, review the portfolio to ensure the new allocation aligns with your investment goals. If any equity units were sold at a gain, record the realised profits carefully for tax purposes, as portfolio rebalancing can trigger taxable events.
How To Rebalance A Mutual Fund Portfolio: Step-by-Step Process
Optimum mutual fund portfolio management requires rebalancing of a mutual fund portfolio. Therefore, below is a detailed guide on how to rebalance a mutual fund portfolio.
Step 1: Review Current Portfolio Allocation
Understanding when to rebalance a portfolio is key. Investors must review their portfolio after set intervals, like monthly or quarterly. The interval might be set according to the individual requirements of an investor. For instance, if an investor invests in money market funds, they can review their returns annually because the category average has remained consistent at around 7% over one, two and three years2.
| Tenure (years) | Category average (%) |
| 1 | 7.56 |
| 2 | 7.36 |
| 3 | 7.06 |
Moreover, during certain key events, an investor might be compelled to rebalance his portfolio. Reviewing the portfolio might enable an investor to target underperforming units.
Step 2: Identify Deviations from Target Allocation
Continuous monitoring might reveal patterns and trends of deviations. Based on these portfolio drifts, investors can make portfolio decisions. It is important to remember that markets are subject to fluctuation.
Therefore, market-linked securities are subject to normal fluctuations. Consistent and exponential decline can call for precautionary measures.
Step 3: Deciding What to Buy or Sell
Continuous monitoring might reveal systematic portfolio drifts. Moreover, a sudden, unanticipated decline due to a market event or otherwise may call for action. Precautionary measures may include selling existing securities and buying new assets.
For instance, suppose Mr A wants to maintain a 6:4 mix of equity and debt. However, after 5 years, his portfolio looks like this.
| Equity mutual fund units | 210 |
| Debt mutual fund units | 300 |
Currently, his ratio stands at 7:10. Therefore, to maintain his original investment plan, he decided to sell 140 units of a debt mutual fund and buy 30 units of an equity mutual fund.
| Equity mutual fund units | 210 + 30 = 240 |
| Debt mutual fund units | 300-140 = 160 |
Therefore, his equity-to-debt mutual fund ratio is restored to 6:4.
Step 4: Execute the Rebalancing
Once the investor has determined what assets need to be bought or sold, the investor can execute their rebalancing decision. However, before executing it, he should consider the tax implications of rebalancing.
Rebalancing involves selling securities, resulting in capital gains. Capital gains are taxable according to the following table2.
| Fund type | Holding period (on or after 23rd July 2024) | Tax rate |
| Equity | STCG: Less than or equal to 12 months | 20% |
LTCG: Greater than 12 months (applicable above INR 1,25,000) | 12.5% | |
| Debt / Non-equity | STCG: Less than or equal to 12 months in the case of listed companies and 24 months in the case of unlisted companies. | As per the income tax slabs |
| LTCG: Greater than 12 or 24 months | 12.5% |
Step 5: Monitor and Repeat Regularly
Once the rebalancing is completed, investors must continue the periodic monitoring to gauge the result of their rebalancing measures.
Portfolio rebalancing is a continuous effort that ensures capital preservation and appreciation.
Why Is Portfolio Rebalancing Important?
The understanding of how to rebalance mutual funds is incomplete without gauging its importance. Therefore, the importance of portfolio rebalancing is discussed below.
1. Maintaining Desired Asset Allocation
There is a wide range of assets available for investment, ranging in terms of risk, return and other parameters. Investors choose their assets based on their financial goals and current circumstances.
For instance, a 65-year-old retired senior citizen might choose to invest predominantly in debt for stable returns and safety of capital. In contrast a 30-year old employed individual can choose a 7:3 ratio of equity to debt due to his higher risk tolerance.
However, over time, the actual portfolio allocation might change. Moreover, a particular asset might not perform as expected.
In such a scenario, a portfolio rebalancing strategy might help in realigning the portfolio with investment goals.
2. Managing Risk and Volatility
Continuous monitoring reveals trends and deficits in a portfolio. Investors can avoid over-reliance on certain assets through portfolio rebalancing. Moreover, continuous monitoring reduces market-linked volatility through corrective actions, resulting in diminished risks.
3. Optimising Returns Over Time
Portfolio rebalancing aims to prevent loss of capital through continuous monitoring and corrective actions. Therefore, over time, the portfolio as a whole ensures optimum results. Investors can do away with poor-performing securities and diversify more into profitable assets.
When Should You Rebalance Your Mutual Fund Portfolio?
The most dominant subtext of how to rebalance a mutual fund portfolio is when to do it. Overtrading of a portfolio indicates unplanned investing and not only increases the risk but also diminishes returns by restricting the law of compounding. There are two major classifications of planning rebalancing.
1. Time-Based Rebalancing
Based on historic trends, investors can choose to rebalance a portfolio after set intervals like annually, monthly, quarterly or semi-annually. If the majority of assets held in the portfolio have consistent patterns, the investor can choose time-based rebalancing.
2. Threshold-Based Rebalancing
In this case, investors must determine a tolerance band. It refers to an average metric regarding price, risk, or quantity of units beyond which is considered a deviation that requires corrective action. For instance, an investor wants to maintain a 40% share of debt mutual funds. His tolerance band is +/- 5%.
| Share of debt mutual fund in a portfolio | Tolerance band | Will he rebalance his portfolio? | Reason for decision |
| 36% | +/- 5% | No | Within the tolerance band. |
| 42% | +/- 5% | No | Within the tolerance band. |
| 30% | +/- 5% | Yes | Crossed the tolerance band. |
| 46% | +/- 5% | Yes | Crossed the tolerance band. |
Tips For Portfolio Rebalancing
A few portfolio rebalancing strategies are discussed below. Investors should keep them in mind before rebalancing.
1. Clear financial goals: Investors must set clear financial goals regarding risk, return and other factors before investing. Clear goals are key to understanding deviations from the set standards.
2. Rebalancing strategy: Rather than choosing between time-based and threshold-based rebalancing, investors can create a blend between the two strategies. For instance, Mr A checks his portfolio quarterly. However, take corrective actions only when an asset has crossed a threshold.
3. Taxability: There are tax implications of rebalancing. Rebalancing actions create capital gains in case units are sold. Investors must perform optimum tax planning before rebalancing.
4. Avoid unnecessary action: Unnecessary changes in the portfolio increase the degree of risk associated and also diminish returns. The mutual fund units might be unable to benefit from the law of compounding.
5. Professional help: In the case of amateur or underconfident investors, a professional investment advisor might be consulted for feedback and assessments.
Time-Based Vs Threshold-Based Strategies
There are two categories of strategies to rebalance a portfolio: time-based and threshold-based. Time-based strategies involve reviewing your portfolio at regular intervals, e.g., once per quarter. Therefore, it will always be possible for a steady investor to keep an eye on their investments throughout the year.
Threshold rebalancing would only activate when your investments experience significant movement; as such, it may potentially save you money since fewer transactions are done.
Ravi utilises a 5% band with this strategy. For example, he will only perform a rebalancing of the mutual fund if his equity allocation has shifted to 75% or 65%.
The best way to achieve optimum results from rebalancing a portfolio is to combine a time-based strategy with a threshold-based strategy.
Quarterly scans allow you to regularly monitor your portfolio for drift and utilise the threshold rebalancing to capture large shifts in asset classes without being over-traded in periods of relative stability.
Tax Implications: STCG/LTCG On Equity And Debt Funds
A tax is levied on rebalancing because selling equities creates capital gains when making a mutual fund portfolio adjustment. For equities, the capital gains tax is levied at a short-term capital gain rate of 20% if held for less than 12 months, and 12.5% for long-term capital gains if held for over 12 months. For debt, you are taxed at slab rates for short-term and at a flat rate of 12.5% for long-term capital gains.
When Ravi sells equities that have been held for more than 1 year, he incurs a 12.5% long-term capital gains tax on the amount that exceeds Rs 1.25 lakh. When he sells debt that has been held less than 24 months, his gains will be taxed at his income tax slab, which could range up to 30%. The best strategy for optimising taxes for rebalancing is to plan to do it around your tax year-end.
The best way to minimise the tax effects of the rebalancing is to harvest any losses before taking any gains; this will reduce the tax you will incur when doing a rebalancing. Hence, it makes sense to hold onto your winning investments for the long term in order to take advantage of the lower long-term capital gains rates.
Maintaining Risk-Adjusted Asset Allocation
The allocation of assets is a major driver of returns and serves to manage the associated investment risks of mutual fund investment.
The age, objectives and risk tolerance of an investor create an initial asset allocation (i.e., 70%/30% for younger investors) based on their life stage. Portfolio rebalancing is essential to maintain a mature allocation, as the market makes natural adjustments over a time period.
While being your own, you must have an allocation of 70% in equities and 30% in bonds. Rebalancing regularly will restore the original proportions by selling excess equities and increasing the bond portion back to its original percentage.
As an investor ages, the recommended allocation should move towards 60% to 40%. The investor's reliance on rebalancing to enforce the glide path toward their targeted allocation is natural. Investors should also use a threshold rebalancing methodology to maintain their risk exposure.
Common Mistakes To Avoid In Rebalancing
- Investors often make the mistake of trying to anticipate or "chase" performance, or neglecting to consider the costs associated with rebalancing their portfolios.
- Some investors also tend to ignore the tax implications of rebalancing their portfolio and will end up with a large tax bill as a result of making too many trades.
- Rebalancing on a monthly basis will result in significant transaction costs, which do not outweigh any potential benefits.
- Many investors do not recognise that portfolio drift results in increased concentrations of risk to the extremes at which they are currently allocated.
Conclusion
Understanding how to rebalance a mutual fund portfolio can help investors take preventive actions that can aid capital preservation and appreciation. Moreover, it may also reveal historic trends that can aid further optimised investment decision-making. However, the investor must consider the frequency of rebalancing, along with tolerance bands. It can eliminate unnecessary actions. Moreover, the tax implications of rebalancing should also be considered before executing it.
The process of investing starts with monitoring, which reveals portfolio deviations. Investors can choose to correct these deviations by selling and buying the units. However, in the case of amateur or underconfident investors, investment advisory services can be availed.
Grip Invest offers a range of securities and asset baskets. Investors with limited investible funds can get the advantage of a well-diversified portfolio through these baskets. Visit Grip today! Happy Investing!
FAQs On How To Rebalance Mutual Fund Portfolio
1. How often should I rebalance my mutual fund portfolio?
Most investors will benefit from quarterly portfolio reviews with a 5 to 10% Threshold, which is when they will typically look to rebalance their portfolios. However, there may be reasons for other investors to either increase or decrease the frequency of their portfolio rebalancing activities.
2. What triggers portfolio drift in mutual funds?
Market conditions are changing constantly, with stocks and bonds' relative strength changing as well. By reviewing your portfolio regularly, you can spot these types of changes early.
3. Does rebalancing create tax liabilities?
Yes. If you sell mutual fund units, you will be subject to "Long-term Capital Gains Tax (LTCG)" or "Short-term Capital Gains Tax (STCG)," depending on how long you held the unit and the fund you sold.
4. Can I automate portfolio rebalancing?
Yes, many brokerage firms have systems that allow you to specify a target allocation for your portfolio and make trades automatically to maintain that allocation
References
1. Morning Star, accessed from: https://www.morningstar.in/tools/mutual-fund-category-performance.aspx
2. Association Of Mutual Fund In India, accessed from: https://www.amfiindia.com/investor-corner/knowledge-center/tax-corner.html
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