Rebalancing

What is rebalancing? In broad terms it is the alignment of a portfolio to its optimal asset composition based on the desired risk tolerance of a particular investor. The rebalancing of investments is the trading strategy of bringing a portfolio that has diverged away from a target asset allocation back into line. This can be applied by a portfolio manager adjusting asset class weights by selling assets that have become overweight due to price movements and using the proceeds to buy assets in a class that have become underweight (Ang, 2014). Furthermore, it applies to the fund manager adding or removing cash from a portfolio, and allocating new liquidity into an underweight asset class or withdrawing from an overweight asset class.

Rebalancing differs from market timing which attempts to forecast future market movements, whereas rebalancing is pre-determined. Rebalancing is a risk-minimising strategy – and even though it is not meant to increase returns, it has the potential to yield better risk-adjusted performance for a portfolio. Having said this, it is important to understand how rebalancing is done through the various approaches and strategies one can implement when revising a portfolio.

Benefits of Portfolio Rebalancing

Earlier it was established that a portfolio should be constructed according to the appropriate risk-tolerance of an investor. The initial portfolio construction can then be regarded as the optimal asset allocation which is appropriate for the investor’s risk tolerance. Therefore, any divergence from this asset allocation is assumed to be undesirable. However, in reality - as Meyer and Urbahn (2015) indicate - “a portfolio’s relative composition changes over time due to the relative performance of the portfolio’s assets. More volatile asset classes such as equities tend to deliver higher returns, implying that, without adjustment, a multi-asset portfolio tends to become very equity-dominated over time.” Therefore suggesting that if left unchecked, a portfolio’s level of risk associated with the equity component increases and may be to the detriment of an investor due to an increased risk of capital loss. Rebalancing benefits the investor by reducing the present value of expected losses and minimises the expected utility loss experienced through a drift in asset mix, i.e. straying from the optimal asset allocation.

According to Overway, Price and Klos (2015), implementing a systematic rebalancing process not only helps maintain a consistent and appropriate level of risk, but in many cases may actually enhance the return of a portfolio. This follows from the disciplined process used to add to the underweight asset class and reduce the overweight assets that are highly appreciated, relative to the investor’s initial strategic asset allocation (SAA).

To offer a rudimentary demonstration of the potential benefits an investor could derive from rebalancing, a comparison of two identical multi-asset portfolios that apply different investment strategies (Buy-and-Hold & Constant-Mix) is used as an example. These portfolios are constructed according to a moderate risk-profiled local investor.

1). Buy and Hold Strategy:

a) Initial asset allocation for a R10,000 investment as at 1 October 2006 – invested over 10 years

Equity (ALSI) - 60%
Bonds (ALBI) - 30%
Cash (STeFI) - 10%

b) Asset allocation after 10 years: (Drift in asset mix)

When comparing the two strategies the following empirical argument can be made for why rebalancing a portfolio is a necessity. The constant-mix strategy produced a higher investment growth over the 10 year period (Figure 4). The rolling volatility associated with the rebalancing strategy was lower over more periods than the buy-and-hold strategy (Figure 5) and also produced lower drawdowns, particularly in times of market stress (Figure 6) - thus showing a better ability to preserve capital, whilst offering a higher return than the buy-and-hold strategy.

Although there is minimal difference in investment growth (Buy-and-Hold: R27,429.77; Constant-Mix: R27,725.43) between the two strategies, there is a slightly better performance achieved using a rebalancing strategy. Also, it should be kept in mind that the point of a rebalancing strategy is not to deliver excessive outperformance but rather to act as a strategy to minimise risk. This can be seen in the graphs below which demonstrate more periods of lower volatility and drawdowns for the constant-mix strategy.

From the above discussion it is clear that there are notable benefits for actively managing a portfolio according to an investment plan and making necessary adjustments to a portfolio in relation to market movements. However, this practise in itself is not without a drawback. There are costs involved when rebalancing a portfolio and these are discussed further.

Concluding remarks

It is important to invest with patience and discipline. A disciplined approach to rebalancing portfolios annually can create additional return and lower volatility versus never rebalancing or rebalancing during different time periods. While investing for the long term requires patience, a disciplined approach to rebalancing can help create value beyond the cyclical trends of the market.

According to Armstrong (2013), “successful portfolios are based on research and reasonable expectations, not intuition. Illogical investors attempt to guess which manager, stock or asset class will have tomorrow’s best performance.” An undisciplined approach to investing, particularly in times of volatile markets, can have a negative impact on the overall performance of a portfolio. Successful, rational investors excel because of a clear methodology and, of course, discipline. It should be kept in mind that no singular strategy wins every day, month, year or decade. But over time one expects to win far more than one loses. So, it will require discipline during times when the strategy underperforms, and chasing last year’s results is a sure path to encountering a difficult investing experience.

Lastly, a few considerations should be remembered. Rebalancing your portfolio is important to ensure that the risk associated with the portfolio’s asset mix is minimised and should be considered at least once a year. Establish your benchmark asset allocation and adjust it as time passes, or if your investment objectives have changed, revisit your optimal asset allocation based on the risk profile associated with your new objective. Have a long-term investment plan and don't be spooked by market volatility in the short term. Finally, be mindful of the tax implications and costs that arise from rebalancing your investment, as these may affect the long-term performance of your portfolio.