A plain language guide to rebalancing in times of volatility

Rebalancing can materially improve outcomes for investors when done thoughtfully. But it’s a surprisingly complex subject.

Here Pendal senior portfolio manager Stuart Eliot (pictured above) offers some practical, plain-language tips.

REBALANCING is a surprisingly technical subject.

There is no shortage of articles out there that discuss the topic using a load of formulas and heavy-duty number crunching.

Instead, here we’ll explain in plain language the practical aspects, illustrating with examples based on the recent market volatility.

Why rebalance?

Advisors invest considerable time with their clients to determine an appropriate investment portfolio based on important criteria such as risk tolerance, income, stage of life and return objectives.

This is ultimately expressed as a set of strategic or neutral asset allocations to various asset classes or as a risk profile (say balanced) which drives the choice of investment portfolio.

In either case the optimal portfolio expresses assumptions about long-term risk and return behaviour of asset classes. Once the portfolio is established, the relative weights between asset classes will change due to market movements, taking the portfolio away from the optimal asset allocation.

Eventually these changes build up to the point where the investment begins to exhibit risk characteristics different to the optimal portfolio – warranting a rebalance.

For example, let’s say the optimal portfolio holds 50% equities because the client can tolerate a mark-to-market loss of 10% if equities fall 20%.

After a strong market rally, equities now comprise 60% of the portfolio which would result in a mark-to-market loss of 12% in the same scenario. (In addition, diversifying investments have fallen from 50% to 40% of the portfolio, offering less than the intended amount of protection.) This is more than the client would be willing to accept – therefore rebalancing would be required before this point was reached.

Rebalancing is an essential part of managing a portfolio to ensure it remains consistent with a client’s objectives.

How or when to rebalance?

There are three general ways of managing the rebalancing of a portfolio. Each comes with pros and cons.

1. Calendar-based rebalancing

Often portfolios are rebalanced at the end of each month, quarter or after a regularly-scheduled portfolio review. The benefit is they can be planned in advance and can facilitate the bundling together of trades to achieve economies of scale.

However, they tend not to be able to take advantage of large intra-period market movements and can potentially result in significant drift from the optimal portfolio.

(Fun fact: if an investment process was developed or back-tested using monthly data for example, it would be implicit in the investment process that rebalancing was performed at the end of every month.)

2. Trigger-based rebalancing

This means rebalancing the entire portfolio, or an asset class/investment within the portfolio, when a trigger level is reached. A trigger could be the distance of a single investment’s weight from the target, the sum of all absolute differences from target, or an estimate of tracking error relative to the optimal portfolio.

This approach has the benefit of keeping the actual portfolio sufficiently close in character to the optimal portfolio while taking advantage of large intra-period market movements.

However this method is more operationally burdensome because it requires regular monitoring to check whether rebalancing is required.

3. Flow-based rebalancing

There are various approaches to flow-based rebalancing. The following approach is representative. The cash balance in the portfolio goes up and down due to deposits, withdrawals, purchases, sales, income and expenses.

When the cash balance is too high the surplus is used to top up the most underweight investments. When the cash balance is too low additional cash is raised by trimming the most overweight investments.

The main benefit here is that transactions costs are minimised. But if cash movements are small and market movements are large, the portfolio can move a long way from its target.

Which approach is best?

The most appropriate rebalancing strategy depends on an investor’s specific circumstances.

At Pendal Group we manage the rebalancing of our diversified funds using a blend of the second and third approaches.

Each day we monitor the weight of each investment in a portfolio (generally unit trusts for asset class and strategy exposures and futures contracts for active tilts). When an investment gets too far from its desired weight we rebalance back to the target.

As an extra tweak – in asset classes where it makes sense to do so – we often rebalance using futures contracts because these tend to have lower transactions costs than unit trusts or the individual securities they hold.

Apart from staying close to the desired asset allocation, this also imposes a robust discipline to managing the portfolio when things get wild, as they have done recently.

We naturally believe all investments we hold will deliver a positive return over time, although we can’t know when. Therefore as the price of an asset declines, through the rebalancing process we gradually buy more as it becomes cheaper while reducing the holdings of other assets as they become more expensive. Our choice of rebalancing approach is driven by a combination of the structure in which we happen to operate combined with our own research.

Our basic insight is that markets tend to:

1. Trend over days

2. Mean-revert over weeks

3. Trend over months

4. Mean-revert over years.

Trigger-based rebalancing capitalises on the first two of these timeframes. We find that doing so results in better expected returns through time than calendar-based approaches. The latter two timeframes are the domain of our active asset allocation processes.

Rebalancing in volatile times

We’ll conclude with a few insights from the recent volatility which may help in setting up portfolios to benefit from future volatility – when it inevitably arises again.

The first is using flexibility to reduce transactions costs.

As mentioned above, Pendal makes use of futures as part of the management of diversified fund rebalancing. This was particularly useful in March when the equity market was experiencing huge intraday moves on a regular basis – resulting in regular and sizeable rebalancing flows. By trading futures – rather than unit trusts or individual securities – we were able to trade with materially lower market impact.

This also gave us the ability to choose our time and price if desired, rather than being captive to the end-of-day price. Not everyone is able to trade futures, but a near identical outcome can be achieved by holding a portion of the investment in relevant asset classes in highly-liquid ETFs or other passive vehicles – of which there are many to choose from. In fact we do exactly this in our multi-asset SMA portfolio models.

Another insight relates to transactions costs – though in a different way. During the worst of the March equity market plunge, the natural systematic rebalancing flow across the market was to buy equities (which had become under-weight as the price declined) and sell fixed income. In Australia, many fixed income mandates are managed to a government plus credit benchmark. Because of this, redemptions from generalised fixed income placed pressure on already-stressed credit markets, causing some funds to widen their bid-ask spreads. At the same time our longer-term valuation models were telling us credit was attractively cheap and we should be adding exposure in our portfolios – which on the surface would seem expensive given the wider spread.

Fortunately in most of Pendal’s diversified funds we hold government and credit exposures separately within the fixed income asset class. So we were able to “buy” the credit exposure almost T-cost free by executing the rebalancing through selling just the government bond holding. The net result is an overweight to credit without having to pay the wider spread.

Pendal senior portfolio manager Stuart Eliot has day-to-day responsibility for the monitoring and management of all portfolios within the Multi Asset team.

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