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This is an iterative process and as long as the investor remains invested in the portfolio, he or she would need to engage in this process to ensure that the portfolio is in line with the initial investment mandate. This sentiment is reiterated by Steiner (2011) who says, "You truly need to have a process in place for how you're buying, how you're re-evaluating and how to make the changes. Those three things create the process." (Figure 1.)

This article will discuss how and why rebalancing, as a portfolio revision strategy, works as a risk-control approach as opposed to asset managers or investors trying to time the market and not being able to control the risks when markets are adverse. Furthermore, different rebalancing strategies are highlighted that investment advisers and asset managers can implement in order to control risk in their clients’ portfolios.

Figure 1. Investment Management Process

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.

Rebalancing disciplines

Calendar-based approach to Rebalancing

This approach involves periodically (e.g. monthly, quarterly, semi-annually or annually) rebalancing the portfolio to target asset class weights, at a pre-determined date. A large drawback of this approach is that it is unrelated to market behaviour, which could significantly influence the investment value of the portfolio in the long term. The reason for this is that certain rebalancing strategies are more suited for certain market environments and if an investor is not cognisant of whether markets are in a trending or reversal pattern they may succumb to the opportunity cost of implementing the least beneficial investment rebalancing strategy.

Tolerance-based approach to Rebalancing

A tolerance-based approach to rebalancing has the potential to generate excess returns without the need for a contrarian view and can be applied by investors themselves. This simple strategy involves selecting an appropriate strategic asset allocation (SAA) based on risk tolerance, financial and liquidity needs as per the financial planning process. This SAA is then only rebalanced when any of the risky asset class exposures exceed a certain predetermined level, say more/less 5% than the original allocation. This ensures that the portfolio remains consistent with the investor’s risk appetite, while at the same time safeguarding that assets which have appreciated markedly are reduced back to the original target allocation.

In addition to these rebalancing approaches, there are effective investment strategies which asset managers can use to rebalance their portfolios. These are:

  • Buy and hold: This is an investment strategy whereby an investor buys an initial asset mix and subsequently does nothing thereafter, irrespective of short-term price movements. It is often referred to as a “do-nothing” strategy, which results in a drifting asset mix.
  • Constant-mix: This is a strategy whereby an investor rebalances to a constant strategic asset allocation. It contrasts the “Buy and Hold” strategy as it is a dynamic strategy that reacts to market movements. This is in order to maintain stable portfolio systematic risk characteristics over time (CFA Institute, 2016).
  • Constant proportion portfolio insurance (CPPI): This is a trading strategy that allows an investor to maintain an exposure to the upside potential of a risky asset while providing a capital guarantee against downside risk. With this method, the investor sets a floor on the monetary value of his or her portfolio, then structures asset allocation around that decision. The asset classes used in CPPI are: a risky asset (equity & property) and a riskless or low risk asset of either cash or bonds. The percentage allocated to each depends on the "cushion" value, defined as (current portfolio value – floor value), and a multiplier coefficient, where a higher number denotes a more aggressive strategy.

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)

Figure 2

Asset%
Equity67.8
Bonds24.8
Cash7.4
Total100

It is clear to see that the portfolio has drifted from the initial asset allocation, with the equity component of the portfolio now representing a much larger portion of the portfolio (Figure 2). As a result thereof, the portfolio experienced a higher volatility over the investment period.

2). Constant-Mix Strategy: Annual Rebalancing Approach

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:

Figure 3

Asset%
Equity60
Bonds30
Cash10
Total100

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.

Higher investment growth

Figure 4 - Data source: Morningstar

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.

Lower volatility

Figure 5 - Data source: Morningstar

Lower drawdowns

Figure 6 - Data source: Morningstar

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.

Costs associated with Rebalancing

Transaction costs

Transaction costs are a latent concomitant of the investment process which have the power to erode a portfolio’s value over time. For individual securities and exchange-traded funds (ETFs), the costs are likely to include brokerage commissions and bid-ask spreads. For mutual funds, costs may include purchase or redemption fees and ensuing administration costs. However, according to Vanguard Research (2010) rebalancing a portfolio with dividends, interest payments, realised capital gains, or new contributions can help investors both exercise risk control and trim the costs of rebalancing.

Tax costs

Rebalancing a portfolio back to strategic weights may entail the selling of assets which have appreciated in value. Thus, for investors rebalancing in taxable jurisdictions, capital gains tax (CGT) may be due upon the sale of certain assets. For SA investors this is applicable, however, capitals gains tax may be reduced through the use of an annual exclusion (currently R40,000 per annum) available to individual taxpayers.

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.

References

Ang, A., (2014). Asset Management: A Systematic Approach to Factor Investing. Oxford University Press.

Armstrong, F. (2013). Engineering your portfolio for better returns, Forbes, June 2013. http://www.forbes.com/sites/frankarmstrong/2013/06/04/engineering-your-portfolio-for-better-returns/#3fd309f363bb

CFA Institute (2016). Trading and Rebalancing, Performance Evaluation, and Global Investment Performance Standards, CFA Level III Program Curriculum, Vol. 6, 2016. http://www.forbes.com/sites/frankarmstrong/2013/06/04/engineering-your-portfolio-for-better-returns/#3fd309f363bb

Meyer, B. and Urbahn, U. (2015). How often should a multi-asset portfolio be rebalanced? Commerzbank AG.

Overway, C., Price, D. and Klos, P. (2015). Rebalancing Multi-Asset Portfolios: Implementation Considerations, Natixis Global Asset Management. http://mpaoverlay.com/cs/Satellite?c=Document_C&cid=1250194721996&pagename=MPA%2FDocument_C%2FDocument

Rozsa, L. (2009). Time to rebalance investment portfolio? http://www.bankrate.com/finance/investing/time-to-rebalance-investment-portfolio-1.aspx#ixzz4OMYaSJZV

Steiner, S. (2011). How to do an investment portfolio analysis, Bank Rate, March 2011. http://www.bankrate.com/finance/investing/how-to-do-an-investment-portfolio-analysis-1.aspx#ixzz4NXS1Pan2

Vanguard Research (2010). Best practices for portfolio rebalancing.

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