Rebalancing when clients really, really don’t want to

November 6, 2014 Categories: Portfolio Corner
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Most investors want a policy asset allocation that provides the appropriate risk-return tradeoff for their circumstances. But as you know, the actual asset allocation in the policy mix begins to vary immediately as the result of the performance of the asset classes the investor has exposure to.

Regular portfolio rebalancing can help keep investors within their risk comfort zone and on track toward achieving their financial goals. It seems so simple. So then why do some investors (and even advisors) sometimes struggle to remain committed to a disciplined rebalancing approach?

Behavioral barriers to rebalancing

The answer is that certain behavioral tendencies can make rebalancing seem less appealing, particularly in markets trending up or down (markets that in general move up or down over the course of a few quarters). This is because rebalancing during trending markets typically dampens portfolio returns over the short-term as higher returning assets are traded for lower returning ones in the interest of maintaining the targeted risk exposure.

In an upward-trending equity market, rebalancing implies selling the stronger performing asset and buying the weaker performing asset (selling high and buying low). Conversely, in a downward-trending equity market, rebalancing implies buying into the weaker performing asset as prices continue to decline (again − buying low, selling high).

But for many investors, it can be psychologically challenging to sell outperforming assets or buy into weaker performing assets. However, it is during those trending periods that rebalancing helps to maintain the asset class exposures of the target portfolio, and helps to ensure the portfolio is appropriately participating in the ups and downs of the market.

In these times, it’s important to help clients understand the effects of rebalancing over a full market cycle. The following examples can help you do just that.

Rebalancing in upward trending markets

Consider the four years from January 2003 through December 2006, a period when global equities (represented by the Russell Global Index) returned nearly 22% on an annualized basis. As shown in the table below, a diversified balanced portfolio that was not rebalanced did better than a portfolio periodically rebalanced.

Rebalancing chart

Annualized return is the rate of return over the period, expressed on an annualized basis. Annualized standard deviation is a measure of the volatility of the portfolio returns; calculated from monthly returns, and annualized.

However, consider the time periods after this upward-trending market. Investors who did not rebalance likely ended up with portfolios weighted heavily to equities and thus exposed to more equity-market risk than they really wanted over the long term. Annualized return is the rate of return over the period, expressed on an annualized basis. Annualized standard deviation is a measure of the volatility of the portfolio returns; calculated from monthly returns, and annualized.

This point is proven by looking at the eight-year period from January 2003 – December 2010, which includes this same four-year up market and the subsequent four-year period. A portfolio that was rebalanced on a frequent basis during this timeframe maintained the portfolio’s target equity exposure. As markets moved down in 2008 and back up in 2009, this portfolio had much less risk (represented by standard deviation) than a portfolio not rebalanced.

Rebalancing Chart 2

Rebalancing in downward trending markets

Consider the two years from March 2007 through February 2009, a period when global equities (represented by the Russell Global Index) fell over 28% on an annualized basis.

Rebalancing chart 3

During this time, it might have been hard to convince a client to rebalance and buy into weaker performing asset classes. But over the four-year period from March 2007 – February 2011, investors who did not rebalance back to their target portfolio may have missed out on subsequent equity returns.

Rebalancing chart 4

During this four-year time frame, a portfolio that was rebalanced on a frequent basis maintained the target equity exposure throughout the period. After the market bottom in February 2009, the portfolio also participated in the ensuing up-market.

The bottom line

In some shorter time periods, rebalancing can help a portfolio outperform and in others it does not. The important thing is that rebalancing keeps investors on track for achieving their financial goals and within their risk comfort zone over the long term. Certain behavioral biases can make it particularly challenging to commit to a disciplined rebalancing approach during trending markets. Help your clients refocus on the big picture and the long-term value of rebalancing.

Russell 1000® Index: Measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market.Russell 2000® Index: Measures the performance of the 2,000 smallest companies in the Russell 3000® Index, representative of the U.S. small capitalization securities market.

Russell Developed ex-U.S. Large Cap Index: Offers investors access to the large-cap segment of the developed equity universe, excluding securities classified in the U.S., representing approximately 40% of the global equity market. This index includes the largest securities in the Russell Developed ex-U.S. Index.

Russell Emerging Markets Index: Measures the performance of the largest investable securities in emerging countries globally, based on market capitalization. The index covers 21% of the investable global market.

FTSE NAREIT Index: An Index designed to present investors with a comprehensive family of REIT performance indexes that span the commercial real estate space across the US economy, offering exposure to all investment and property sectors. In addition, the more narrowly focused property sector and sub-sector indexes provide the facility to concentrate commercial real estate exposure in more selected markets.

FTSE EPRA/NAREIT Index: The FTSE EPRA/NAREIT Developed Real Estate Index Series is designed to represent general trends in eligible listed real estate stocks worldwide. Relevant real estate activities are defined as the ownership, trading and development of income-producing real estate. The index also includes a range of regional and country indices, Dividend+ indices, Global Sectors, Investment Focus, and a REITs and Non-REITs series.

Barclays Capital Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities.

Russell Global Index: Measures the performance of the global equity market based on all investable equity securities. All securities in the Russell Global Index are classified according to size, region, country, and sector, as a result the Index can be segmented into thousands of distinct benchmarks.

Diversification does not assure a profit and does not protect against loss in declining markets.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

*Diversified balanced portfolio consists of 30% U.S. large cap, 5% U.S small cap, 15% non-U.S. developed, 5% emerging markets, 5% REITs, and 40% fixed income. Returns are based on the following indices: U.S. large cap = Russell 1000® Index; U.S. small cap = Russell 2000® Index; non-U.S. developed = Russell Developed ex-U.S. Large Cap Index; emerging markets = Russell Emerging Markets Index; REITS = FTSE NAREIT All Equity REIT Index (through February 2005), FTSE EPRA/NAREIT Developed Index (March 2005 to present); and fixed income = Barclays Capital Aggregate Bond Index.

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