Portfolio rebalancing: good practice for smart long-term investors

  • Written by 

    Roberta Gamba, Anastasia Swirski, Q4 2015

  • 12/10/2015

One of the most widely accepted sayings in portfolio management is “buy low, sell high”, i.e. buy when valuations/prices are low (cheap) and sell when valuation/prices are high (expensive).

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While the received wisdom is that “buy low, sell high” is the proper way to succeed in financial markets in the long term, the reality is that most people are more comfortable with risk in good times. A good investor needs to have the discipline to buy low and sell high when their emotional state often inclines them to the reverse. This is the essence of portfolio rebalancing: maintaining the discipline of taking profits from expensive assets and reinvesting in cheaper assets.

Rebalancing is an effective portfolio management technique, which allows all investors to keep a tight control around maintaining a diversified exposure. This allows investors to benefit from the less than perfect correlation across all asset classes and, as a consequence, effectively manage the overall market risk taken in portfolios. However, it is not that simple since often when rebalancing is needed, the markets prove to be challenging. As a result of this, a number of factors (for example, market liquidity) need to be considered in relation to the correct timing of the rebalancing exercise.

Time-based versus threshold-based rebalancing

There are a number of different approaches that can be adopted to maintain the discipline of rebalancing portfolios. A lot of investors, generally those less engaged with market activity, rebalance their portfolios on a periodic basis, either quarterly or semi-annually; others, generally those more engaged with market activity, adopt rebalancing practices dependent on market events, the actual deviation of the portfolios from the target allocation, market liquidity, and cost of trading. The former type of investor adopts a time-based rebalancing approach, while the latter adopts a threshold-based approach. Independent of the approach taken, the key message is that any rebalancing discipline (time-based or threshold-based) is better than none at all.

Competing considerations go into rebalancing portfolios which investors should weigh up to determine when and how to do it. Clear benefits of rebalancing include:

1. Effective management of long-term portfolio risk;
2. Maintenance of a diversified exposure, which helps to mitigate the unpredictability of markets; and
3. Removal of emotional trading from the management of the portfolio.

However, when timing rebalancing, an investor should also consider:

1. Market volatility: rebalancing is most difficult in down markets since buying when prices are falling seems unnatural – nobody wants to catch a falling knife. As there is no way to say when the market will reach the bottom, the important thing to remember is that rebalancing helps to manage the market risk within the portfolio. This is exemplified in Figure 1 which shows that in the middle of the 2007-08 financial crisis a rebalanced portfolio1 would have had a lower volatility than one left to drift.
2. Trading costs and market liquidity: rebalancing may incur transaction costs from entering and exiting positions. This is a key consideration when market liquidity conditions are extremely tight, thereby increasing trading spreads.
3. Tax considerations: frequent rebalancing may generate capital gains tax liabilities; however, in some instances, realising small amounts of capital gains over time can be more beneficial compared to realising a large capital gain at some point in the future.

Tax rules may change. The value of the benefits, and the other effects, of any particular tax treatment for an investor will depend on that individual’s circumstances. We do not provide any legal or tax advice and recommend that you obtain your own independent legal advice and independent tax advice, tailored to your particular circumstances.

FIGURE 1: During stressed market periods, portfolios exhibit higher volatility, but rebalancing portfolios can help to reduce the volatility

The impact of portfolio drift

Over time, investments will deliver varying rates of returns (for example, stocks may outperform bonds or vice versa) according to their level of risk (Figure 2). Eventually, these market forces will cause the value of holdings in various asset classes to change or drift from their initial positions and potentially change the risk profile of a portfolio. Asset classes that outperform relative to others over a period of time will represent a larger proportion of the overall portfolio. Figure 3 illustrates how market movements drive the evolution of the portfolio allocation when the portfolio is left to drift, which will cause fluctuations in the risk of the portfolio over time. It is these market movements that may consequently lead to the need to rebalance portfolios.

FIGURE 2: Lower volatility assets (e.g. cash) tend to pay relatively lower returns compared to higher volatility assets (e.g. equities).FIGURE 3: Over time, an IP3 non-rebalanced portfolio initially invested in 1990 will experience significant deviations in asset allocation, which affect the portfolio’s risk profile.

Rebalancing portfolios is essential to ensure asset allocation policies are maintained and risk is appropriately managed. As Figure 4 illustrates, the equity exposure, when left to drift, can vary quite considerably with respect to the target allocation due to the high volatility of the asset class. While a decreasing equity exposure might look a good thing in down markets, we need to remember that the best performing days in markets are actually just after turbulent times – exactly when investors are less keen to put money to work. As Figure 5 evidences, the best 10, 15 and 20-day returns on the S&P 500 were captured at the end of the first quarter in 2009, when the markets began on an uptrend from the crisis low. The S&P 500 had sunk to 676 and was now back on an upward trajectory. This, combined with central banks cutting rates in the previous two quarters and announcing plans for fiscal stimulus and stability programmes, led to high performance.

FIGURE 4: Equity allocation evolution (Mar-90 to Sep-14). FIGURE 5: The best performing 5-day period over the last 20 years was in Q4 2008

Maintaining the discipline of rebalancing removes emotions from the decision-making and allows portfolios to capture the long-term benefit of being invested.

Allowing portfolios to drift leads to the greatest deviation from the target allocation, as Figure 6 illustrates. A quarterly rebalancing of the portfolios, or a 2% threshold rebalancing, generally provides a close tie to the desired target allocation, with the latter approach being preferable to the former when the investor has the necessary market knowledge since it should lead to fewer transactions (Figure 7).

Investors should also consider that an efficient way to rebalance a portfolio is to use cash flows to better align the target allocation, either by adding to underweight assets (in the case of inflows) or by trimming overweight assets (in case of outflows).

In conclusion, our recommendation to clients is to be diligent in rebalancing portfolios to risk manage their portfolios according to their desired risk profile. It is important to remember that any approach to rebalancing (time-based or threshold-based) is better than no rebalancing at all.

FIGURE 6: Less frequently rebalanced portfolios experience higher drift from the original asset allocation over time. FIGURE 7: The number of rebalancing events (and subsequently the trading costs) for the quarterly rebalanced portfolio is far higher.