Determining how to spread your funds across investment asset classes of varying risk and potential return is one of the most important investment decisions you will make.
Ensuring that this allocation continues to meet your risk-return preferences is another challenge, as investments can produce different returns over time and their significance within your portfolio can change. Your desired blend of risk and return can also change over time, as personal circumstances – like nearing retirement or having a family – evolve.
Having a lot invested in equities will likely mean your long-run returns will be higher, but also that you will have to endure volatility along the way. By contrast, allocating a large proportion of your funds to relatively less volatile cash or bonds may mean you sacrifice returns in exchange for greater capital stability.
Ideally, the aim is to have an asset allocation that gets the balance between high and low-risk assets right for you – both now and over time.
The need for portfolio rebalancing
The problem is that asset allocation is not a ‘set and forget’ decision. Your exposure changes as markets move. A strong run in equities will mean the share of your portfolio invested in ‘high-risk’ assets (shares) will increase, making your portfolio more volatile. This may be inconsistent with your desired risk/return profile.
The aim of rebalancing is to adjust your exposure to maintain your target asset allocation.
Another goal of rebalancing may be to preserve diversification within asset classes. For example, if you have significant exposure to bank stocks, and the banking sector has run particularly well, you may end up with an overweight position. You might decide to rebalance to other industry sectors to retain diversification across sectors. The same principle applies to country or regional diversification.
Rebalancing is called for not just when your asset allocation moves out of alignment with your risk profile, but also as your risk profile itself changes over time. For example, it’s generally recognised that as an investor ages, capital preservation, income stability and risk management become relatively more important than they were in the investor’s youth. As you approach retirement, you might seek to de-risk by decreasing your exposure to equities and increasing exposure to cash or bonds.
Portfolio rebalancing can feel counterintuitive
One challenge in rebalancing is knowing when to do it and what to buy and sell.
Rebalancing often essentially involves ‘selling your winners’, which seems to go against an investing rule of thumb to ‘take your losses and let your profits run’. That rule arguably applies more to individual stocks, which in some cases can show outperformance for long periods of time, than it does to asset classes. In the case of broad asset classes, however, there is typically a ‘regression to the mean’, in other words, periods of strong returns are often followed by periods of weak returns. For this reason alone, it can be prudent to trim exposure to asset classes that have run strongly for a period of time.
Research suggests that monthly or quarterly rebalancing is probably too frequent and can also involve excessive trading costs. It also is at odds with the fact that momentum within asset classes is often positive over periods up to 12 months.
By contrast, waiting several years is probably too long due to the regression to the mean principle.
A reasonable compromise is to rebalance around every 12 months. This also may offer tax advantages to eligible investors, as assets retained for more than 12 months are eligible for the capital gains discount when sold.
Another challenge is how to fund re-balancing, as selling one asset to buy another may realise capital gains and incur trading costs.
One option is to reserve income earned on existing assets to fund increased exposure to the desired asset. For example, dividends or distributions taken in cash, and income earned from cash and fixed interest investments, can be used to buy more stocks after a sharemarket decline which has reduced your exposure to equities, or conversely to increase your allocation to bonds/cash if equities have had a strong run and you find yourself with too much sharemarket exposure.
Individual stocks or bonds versus diversified funds
When rebalancing, investors must decide between two broad options:
- buying individual stocks, bonds or other fixed interest investments, and
- investing in a fund or managed investment that offers diversified exposure to the desired asset class.
The challenge of buying individual stocks or bonds is that a lot of research may be called for, and to ensure you have sufficient diversification you will need to spread your funds across several products within the asset class, which can increase trading costs. There is also the risk that you may get the asset class ‘right’ but choose the ‘wrong’ investments within the asset class, resulting in underperformance.
Managed funds, Listed Investment Companies (LICs) or Exchange Traded Funds (ETFs) can offer broad diversification in one trade. ETFs also offer relatively low costs, for example, the ASX:A200 fund gives you broad exposure to the Australian market for an annual management cost of only 0.07% per annum.
ETFs can also allow you, in one or a few trades, to adjust exposure to international equities, or to sectors of the market, for example the Financials or Resources sector. For example, investors in technology can use ASX:NDQ, our NASDAQ 100 ETF.
The benefit of funds like these is that you don’t have to pick which bank/mining/technology stock to buy. You get cost-effective, diversified exposure to the desired sector/region/market in one trade, making portfolio rebalancing simple to achieve.
ETFs also offer attractive options to investors looking to increase their allocation to more defensive assets. It is now straightforward to achieve diversified exposure to corporate or government bonds, assets that previously were hard for individual investors to access, meaning you don’t have to restrict yourself to cash or term deposits offered by the banks. Two examples from our range are ASX:CRED which aims to generate income higher than that paid on cash, term deposits or government bonds. Its returns have also tended to be negatively correlated with equities, helping with portfolio diversification. Or the Active ETF ASX:HBRD where investors gain access to a diversified portfolio of hybrid securities.
David Bassanese is Chief Economist at BetaShares, which offers exchange traded products listed on the ASX. This article contains general information only and does not consider the investment circumstances of any individual. Nasdaq®, OMX®, Nasdaq-100®, and Nasdaq-100 Index®, are registered trademarks of The NASDAQ OMX Group, Inc. and are licensed for use by BetaShares.
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