Investment Strategy-Portfolio Rebalancing

Investment Strategy-Portfolio Rebalancing

 

Why is it important and how you can do it?

Over the course of the year, the market value of each security within your portfolio earned a different return, resulting in a change in the allocation pie. This might change the investor's risk profile. While in the short term this may not have an adverse impact, such changes in risk profiles can have a far-reaching impact in the longer run. Portfolio rebalancing is a strategy that allows individuals to keep their risk level in check and minimize risk.

What Is Rebalancing?

Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation.

Assume an investor's portfolio worth Rs 1,00,000 is invested in equity funds (40%), Bond Funds (40%) and liquid funds (20%). In other words, Rs 40,000 will be invested in equity funds, Rs 40,000 will be invested in bond funds and Rs 20,000 will be invested in liquid funds. Let's assume that in Year 1, equity funds deliver 20% return, bond funds loose 2% and liquid funds give a modest 4% return. His portfolio, at the end of the year, will look like this:

 

Year 1	Returns	Opening	Closing
Equity Funds	20%	40000	48000
Bond Funds	-2%	40000	39200
Liquid Funds	4%	20000	20800
Total		100000	108000

 

Overall, the portfolio has returned 8%, but that's more due to the equities.

In year 2, assume the rise in the equity markets gets over and markets fall. So assume equity funds return -10%, bond funds on the other hand rebound and return 9%, while liquid funds continue with 4%.

Now assume two scenarios, viz. one where the above investor switches back to his original asset allocation, and the other where the investor doesn't reallocate his assets as per his original allocation and ignores the change.

		Rebalance portfolio		Ignored portfolio
YEAR 2	Returns	Opening	Closing	Opening	Closing
Equity Fund	-10%	43200	38880	48000	43200
Bond Funds	9%	43200	47088	39200	42728
Liquid Funds	4%	21600	22464	20800	21632
Total			108432		107560

As per the above example, while the rebalanced portfolio appreciates to Rs 1,08,432, the value of the ignored portfolio actually falls to Rs 1,07,560. As can be seen, the ignored portfolio got swayed by the equity return in Year 1 and therefore chose not to go back on the original asset allocation, not knowing that equities as an asset class can be quite volatile in the short run. A fall drop in the equities in Year 2 was enough to result in the ignored portfolio to under-perform the rebalanced portfolio.

Rebalancing strategy is, therefore, the optimal strategy.

Benefits of portfolio rebalancing

Disciplined investing

Rebalancing is a vital part of investment policy - there can be no asset allocation target without the discipline to preserve that target.

Reduces risk

A plan may incur higher risk if no rebalancing policy exists. This is true particularly for equity allocations, which can rapidly rise in a bull market. For instance, portfolio rebalancing ensures that in rising equity markets, the asset allocation doesn't get skewed towards equities and the portfolio correctly reflects the investor's risk profile. It also ensures that the portfolio is adequately diversified. 

Buy low, sell high Rebalancing is a mechanism for sensible timing - the process naturally buys low and sells high. This strategy ensures that the portfolio returns are enhanced. A clear rebalancing policy avoids the risks of ad-hoc and costly portfolio revisions. 

Balanced Funds - a better way to portfolio rebalancing

One way to rebalance the portfolio is to do it ourselves. In other words, investments can be made in equity and debt funds separately and then adequate rebalancing can be done depending on how the equity and debt markets perform.

A simple way to ensure portfolio rebalancing is to invest in Balanced Funds. Here, the fund manager does the rebalancing and not the investor. Usually, all balanced funds invest around 60-70% in equity markets and the rest in debt and money market instruments. They state their asset allocation, i.e. their allocation towards equity and debt instruments, in their offer documents for investors to refer to. Further, they are mandated by Sebi to stick by their stated allocation.

So when equity markets keep rising consistently, Balanced Funds are mandated to book profits and bring their equity allocation back to their stated levels. This way, balanced funds carry a low downside risk as when equity markets fall, balanced funds take a lesser hit than equity funds.