THE ART OF REBALANCING YOUR INVESTMENT PORTFOLIO

Rebalancing can be done systematically or strategically, but it must be done with purpose to keep the allocated target weights in balance.

How important is it to rebalance your investment portfolio? Or shall I ask, is it necessary to ever rebalance your portfolio?

We regularly hear that the only free lunch in investments is diversification. We constantly also hear the debates about active versus passive, growth versus value, and local versus offshore and the debates carry on infinitum.

For equity purists who only believe in investing in equities, the rebalancing debate is one of choosing and rebalancing different sectors or themes. For multi-asset investors, the debate is about how much equity/property versus bond/cash exposure is optimal and how often must a portfolio be adjusted or rebalanced.

For the purpose of this article, I am going to focus on multi-asset investing and try and make some sense of optimal asset exposure and optimal rebalancing.

Before I dive into my analysis I want to make a statement by saying that irrespective of what asset class you invest in, you will experience positive returns if you remain invested in that asset class for a very long period (say more than 15 years). How those returns will be achieved and experienced will depend on global economic conditions, interest rate trends and the impact that tax and inflation have on each respective asset class. How effective your returns are, will be determined by how and when you take exposure to certain asset classes and when you move to over and under exposure to specific asset classes. For South Africans, we can add currency fluctuations to this list. I don’t have to tell you what impact currency movements have on local as well as offshore investments. This effectively means that South African investors probably experience more volatility (positive and negative) within their investments than developed world investors do. We also have an extraordinary choice of investments globally with more than 120 000 funds, shares, ETFs, tracker funds etc. We technically have more investment choices than the average American investor. That also creates more challenges for us…

Given the potential complexities within portfolios where equities, bonds, cash, property, hedge funds, gearing, quants and heaven knows what can be used, the turmoil can be increased by incorrect rebalancing strategies. For explanatory purposes, I am going to keep it simple and adopt the US principle of a 60/40 portfolio that is commonly used for US retirement funds, meaning 60% exposure to equities and 40% exposure to bonds. I am going to ignore cash and property and taxes. All that I am interested in is establishing what the impact will be of rebalancing a 60/40 portfolio too often or not often enough.

Considering all the benefits of diversification, we must realise that diversification is only effective if there is a coherent asset allocation and a coherent rebalancing process in place.

The rebalancing can be done systematically or strategically, but it must be done with purpose to keep the allocated target weights in balance. The allocated target weights of the underlying asset classes will be determined by the risk parameters you set for your investment and will be guided by the amount of risk/volatility that you are prepared to accept within a particular portfolio.

The graph below shows the results of what Vanguard found when they did a deep dive on various rebalancing intervals that range from 1928 to 2022 last year using a global 60/40 portfolio. They found that rebalancing too frequently or too infrequently are suboptimal strategies.

The optimal interval from a risk control perspective was an annual rebalance.

Daily or too regular rebalancing generated the worst results.

Rebalancing can be done in many forms or formats. As South Africans, we are very familiar with multi-asset funds (low equity, medium equity and high equity or balanced funds). It is interesting to note the views of different fund managers in particular when it comes to equity, bonds and offshore exposure within the same risk category. It is not unusual to see in different funds equities varying between 58% and 72%, bonds varying between 6% and 25%, cash varying between 5% and 20% and offshore varying between 28% and 45% in the high equity Regulation 28 sector. The fund managers who manage these funds are all very smart people. How come the variances are so extreme?

Plainly because in multi-asset funds rebalancing is not an exact science.

The 60/40 principle is a simple strategy which has worked well over many decades. It remains to be seen how effective it is going to be over the next decade. True multi-asset funds have more parameters that need to be considered. There are at least four asset classes to consider, and each asset class has sub-sector assets each with its own characteristics. Fund managers also have the option to hedge out some risk and to place protection on portfolios. Offshore allocation comes into play as does thematic investing. Modern investing is no longer just about equity/bond play. There is much to consider and I, for one, will be worried if my multi-asset fund managers do not review their strategic and tactical asset allocation more regularly than once per year…

If your strategy is to invest in passive funds and you keep it really simple by adopting the 60/40 principle then bringing the asset allocation back to 60/40 once per year will more than likely keep on providing satisfactory results.

If you intend to use multi-asset actively managed funds it will be a good idea to get to know the managers well that you intend to use. Blending managers that are not correlated is a form of further diversification. If you intend to add some specialist funds (as I like to do), to get to the upper limit of Regulation 28 limits you are fortunate enough that the regulation will keep you in check and force you to rebalance once per year back into the set limits of 75% equities, 25% property, 10% hedge with maximum 45% offshore exposure.

You will still however need to make the decision on which asset class you want to overweight within your portfolio should you wish to do so. For young investors (and more assertive investors) equity and offshore exposure can be maintained close to the upper limits of Regulation 28 and there are very few fund managers that maintain those levels. You will therefore have to make some decisions…

Remember – knee-jerk reactions of moving to cash or from one underperforming fund to another when markets start to rumble is not rebalancing! It’s a guaranteed way of ensuring underperformance.

Keep on rebalancing (not too often though) and stay invested!