What rebalancing a portfolio means and why it is so important (Part2)

In our last blog we looked at why an active rebalancing policy is essential and why is balance so important?  Now we will consider why an unbalanced portfolio is more risky and how it works.  Let now continue.

Why is an unbalanced portfolio more risky?

Seduced by high returns, an investment manager might be tempted to leave a portfolio of high-performing shares or equity funds to grow. The problem is that they may also end up dangerously exposed. The results can be both painful and swift.

Perhaps the most traumatic illustration was in 1974, when the FTSE All-Share Index fell by more than 70% – very bad news for anyone holding a UK share portfolio. Black Monday in October 1987 wasn’t that great either: by the end of the month, the US Dow Jones Industrial Average was down by 22% and the UK market was off by 26%. In 2008, the year when the credit crunch kicked in, the FTSE 100 index fell by 31%. And bonds can suffer too: in 1994 unexpected interest rate rises by the US Federal Reserve helped to wipe a cool $1.5 trillion from world bond markets. It is true that markets do come back from such losses, but it often requires a strong stomach to last the journey. For an investor, not having all your eggs in one basket can both protect wealth and give the confidence to stay aboard.

How does rebalancing work?

The main rebalancing approaches are either “periodic”, based on set time intervals such as every quarter, or when differences in performance cause the asset allocation to drift away from its target by more than a certain percentage. This is known as “band” or “range” rebalancing. To see how these strategies affect long-term returns, they tested the 60/40 portfolio over the nearly 80-year period since 1940 using different rebalancing strategies and none at all. (This was the longest set of reliable data they could find.)

They tested nine rebalancing portfolios and one with none, our “drift” portfolio. In terms of absolute returns, the drift portfolio performed best, with a 10% annual return. However in risk-adjusted terms, which they defined as annualised returns divided by annualised volatility, it performed the worst. Indeed, every portfolio which used a rebalancing policy, be it periodic or range based, outperformed the drift portfolio in risk-adjusted terms (see chart).

Doesn’t regular rebalancing incur costs?

It is true that regularly buying and selling assets is a more costly strategy than leaving a portfolio alone. As well as commissions paid to brokers, the typical spread between selling and buying prices also works against the frequent trader.

For the purposes of illustration, they have ignored such costs, but they acknowledge that they can be substantial enough to outweigh the benefits of rebalancing. Choosing the optimum rebalancing strategy therefore involves a trade-off between the best risk-adjusted returns and the lowest level of costs consistent with achieving those returns.

Is rebalancing just an automatic process?

In short, no. Our research shows clearly that, while a rebalancing strategy should follow set rules, it also necessarily requires judgement. Not only do investment managers have to decide whether to rebalance or not, but also how frequently, the target allocation and the way the strategy should be implemented, among other things. Having the expertise to time rebalancing strategies based on economic environments can be difficult, but experience suggests that having such a policy in place should help greatly during times of market stress.

 They conclude that, even when markets are doing well, rebalancing produces superior risk-adjusted returns compared with doing nothing.

As an integral part of the investment process, rebalancing should therefore bring rigour and discipline to the construction of the portfolio, while providing free long-run risk management. This is a combination that should commend itself to all, allowing everyone to sleep that bit easier at night.