The most underrated and underappreciated aspect of financial asset management is rebalancing.
Even professionals, in my experience, underestimate its importance. Sometimes it is barely an afterthought. This is unfortunate because it is of vital importance. It certainly dwarfs a decision like whether one should sell one bank and buy another, which is the type of decision asset managers spend an inordinate amount of time on.
Rebalancing is simply adjusting a portfolio’s asset, sector or individual mix with time to reflect changes in prices. A simplified example will illustrate this issue. If a portfolio is weighted at the standard 60 per cent stocks and 40 per cent bonds on day one, the value of those assets change and so do their weight.
In our example, if a year later, stocks rise 30 per cent and bonds fall 10 per cent, the asset mix changes dramatically if there is no rebalancing. A $100,000 60-40 portfolio will now be worth $114,000, a return of 14 per cent. Now we have a 68-32 portfolio. Depending on the actual price path of both assets, the decision not to rebalance resulted in a higher return than if there were frequent rebalancing. This is because the winners were allowed to run while losers were reduced in exposure merely owing to market action.
While the portfolio has risen in value, it is now riskier. If stocks continue to outperform bonds, the portfolio will do well but there is a negative here in that overall risk will rise.
If in the next year stocks decline by 25 per cent and bonds rise by 10 per cent, the portfolio will be worth $98,100, yielding a two-year annualized loss of about 1 per cent. Things look great until you realize you had your highest weight of an asset at its absolute peak.
If the investor had rebalanced the portfolio back to 60-40 at the start of year two, the portfolio would be worth $101,460, a two-year annualized return of 0.7 per cent, or an annual return of 1.7 per cent above the non-rebalanced portfolio.
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Rebalancing generally decreases the return during periods of high momentum when assets are going up. This has been true most of the time in the equity markets over the past few years. By contrast, rebalancing pays off when markets are choppy and going up and down, because you generally end up switching to the asset that does better. In all market conditions, rebalancing decreases risk.
This goes against the cliché of letting your winners ride, cutting your losses. Instead, rebalancing essentially buys low and sells high.
The decision when to rebalance is not an easy one. It could be done quarterly, or even annually. Or, a rebalancing can be made when one’s asset mix reaches a certain level. For example, if stocks get to 65 per cent from 60 per cent one may want to rebalance back to 60 per cent. One may also wish to rebalance when a significant amount of cash goes in or out of an account.
Regardless, rebalancing should always be top of mind. I have seen professional money managers fall into the trap of ignoring it. And the more volatile the asset, the more important the decision becomes.
I have seen superstar managers give up years of performance, partially because they allowed their best performers to dominate their portfolio in terms of weighting, and then saw those stocks crash at their highest weight. Small-cap managers are especially susceptible to this mistake.
For example, if a stock has an initial 2-per-cent weight in the portfolio and then rises to 8 per cent because of gains, that stock might crash at its peak weighting, more than offsetting prolonged periods of gains. This happens more frequently than most portfolio managers will admit. I have seen situations where managers accused accountants of calculating returns wrong simply because they did not understand the simple mathematics behind this phenomenon.
When looking at the next few years, I believe real returns will be far below the 2009 to 2022 period, in part because equity valuations are currently high. Volatility is going to be on the rise. Performance of different asset classes are likely to oscillate. Frequent rebalancing will yield a superior risk-adjusted return compared to non-rebalancing.
Remember, even the best professionals do not get market timing right consistently, regardless of what their marketing people will tell you.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
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