Steady On!

"Balance - An even distribution of weight enabling something to remain upright and steady"

Perfection is the sum of doing lots of little things well. As professional investors we are obsessed in the pursuit of finding that extra 0.01% to enhance the future outcomes for our clients. While we have various investment strategies, one of the simpler and more noteworthy techniques we use is proactively rebalancing each of our clients’ portfolios.

Let’s start things off by briefly introducing the basic portfolio construction process. When designing a portfolio, the single biggest driver behind portfolio returns is asset allocation - which some studies have shown to account for up to 90%. When deciding an appropriate asset mix for a client’s portfolio, we must carefully fuse together their attitude to risk, capacity for loss, time horizon, financial goals, and objectives into a breakdown of portfolio assets.

However, over time markets will inevitably move, which leads to fluctuating returns across assets - with some producing positive returns and others negative. Naturally, if no action is taken, the level of risk taken in the portfolio will drift away from the intended allocation and could become unsuitable for the client - not to mention, impair all the hard work that went into composing the original allocation in the first place. For a medium-risk investor with a balanced portfolio of bonds and equities, we would expect to see equities outperforming bonds in the medium to long term and allocation of the portfolio drift higher towards the equity side.

This is where rebalancing comes into play. Rebalancing a portfolio involves selling the excess from the assets in the portfolio that has generated a positive return and buying more of the assets that haven’t. This is done to bring the portfolio’s asset allocation back in line with the original investment strategy. Initially, it may seem counterintuitive to sell assets that are performing well in favour of assets that aren’t. However, we are simply selling assets when they are high and buying them when they are low in a systematic process. Furthermore, by remaining disciplined and faithful to the original strategy we can prevent negative behavioural biases and avoid falling into the trap of making tactical short-term bets against ourselves.

Great, so how do we go about rebalancing?

Essentially, there are two main methods of rebalancing – calendar-based and threshold-based. A calendar based involves rebalancing the portfolio at regular intervals (annually, quarterly weekly). Threshold-based rebalancing allows the portfolio’s allocations to drift at pre-determined thresholds and will only trigger a rebalance once that threshold has been breached. There’s a vast amount of literature out there to support/disprove each method along with complex mathematical models which can make choosing the right method confusing. This is further compounded when we consider that a typical investor may have 15+ funds split across multiple wrappers with different tax treatments and strategies.

When analysing the effects of rebalancing on our portfolios, our in-house research found that the optimal method for us in terms of rebalancing was calendar based and the optimal frequency was annually. What was interesting was that increasing the frequency of rebalancing to quarterly, monthly, and even weekly didn’t improve the outcome, and in fact did the opposite and hindered returns. Therefore, it must be implemented with great care.

So, the big question is, what’s the gain in terms of performance I hear you ask. Okay, are you sitting down? A whopping… wait for it… 0.24% each year over the course of ten years. Granted, this may seem like an infinitesimally small improvement in returns, this singular percentage doesn’t reveal what’s behind the bigger picture. Clearly, the main objective for rebalancing isn’t for returns, it’s to manage risk. The 0.24% quoted is in absolute terms. However, what we found was the level of risk taken between the unbalanced and rebalanced wildly different. The unbalanced portfolio had a significantly higher level of equities due to allocation drift and higher investment risk compared to the balanced portfolio.

Ultimately, rebalancing is a portfolio management technique with very few disadvantages. In the context of a low-cost passive investment portfolio, 0.24% would be enough to offset the ongoing costs charged by the fund managers. This means investors in a low-cost portfolio would essentially have their fund charges paid for by opting to rebalance. Due to its many advantages, we believe that rebalancing is one of the many methods in which we can add value to improve client outcomes.

Lee Nguyen

This blog post is intended for information only and does not represent personal financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The value of an investment can fall as well as rise and is not guaranteed - you may get back less than you paid in.

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