The whys, hows and whens of portfolio rebalancing
Tom McFeat, CBC News
Posted: Jan 11, 2011 10:31 AM ET
Last Updated: Mar 3, 2011 10:24 AM ET
Chances are good that you've heard you should rebalance your investments from time to time. Chances are also good that you may not know whether that has ever been done to your portfolio, whether you have to do this yourself, and if you do, how the heck do you do it.
First, the basics. Rebalancing is nothing more than the process of bringing your portfolio back to the original asset allocation mix you'd decided on. That's assuming you've actually decided on one. Some do-it-yourselfers don't have a formal asset allocation plan; they just buy stuff and hope everything works out in the long run.
The experts say the asset mix decision is critical. Warren MacKenzie, the CEO of Toronto-based Weigh House Investor Services, calls it the most important decision an investor makes. "This is how risk is controlled," he says. "We can't control the markets, but we can control our exposure to the markets — and therefore to risk."
You can't rebalance if you don't have a target asset allocation. Many discount brokers, banks and mutual fund companies have asset allocation tools on their websites. They ask a series of questions to arrive at an appropriate investment mix for you, given your age, years to retirement, income and risk tolerance.
These asset allocation tools will suggest investors buy a certain mix of equities, with the remainder in fixed income and cash/money market funds. They'll often also suggest some funds or "managed solutions" they sell. Whether you take them up on those suggestions is up to you — you can always build one of the many passive "couch potato" or "two-minute" portfolios out there using cheaper exchange-traded funds or index funds. But then you'll have to do the rebalancing yourself.
What's a good asset allocation mix? Adrian Mastracci, president of KCM Wealth Management in Vancouver, asks his clients 36 questions to get a sense of their risk tolerance and, by extension, their approppriate investment mix.
"For most Canadians, they would be comfortable with a mix of 40 to 60 per cent in equities and the balance in fixed income," he says, with older investors having less equity exposure.
Returning your portfolio to its target mix is designed to keep the risk profile the same. If, for instance, you have decided that you're most comfortable with a 50/50 mix of equities and fixed income, a big run-up in the stock market could throw that target way off track. You could end up with 70 per cent of your portfolio being equities and 30 per cent in bonds — in this case, a portfolio that would be too risky for your risk tolerance.
'If you don't rebalance, you have a different risk profile," says Paul Taylor, chief investment officer at BMO Harris Private Banking. That can lead some investors to panic selling when their suddenly equity-heavy portfolio starts diving during a market sell-off. "[Rebalancing] forces the discipline of selling your winners and crystallizing your gains, which is probably a good thing," Taylor says.
In the course of rebalancing, you can also make a decision to adjust your asset mix away from its neutral position. If you think the market is overvalued and ripe for a fall, you could choose to cut your equity exposure below what your target calls for. This is called tactical asset allocation and there are many mutual funds that practise this — with varying degress of success.
How to rebalance
If you find your investment mix has become too skewed away from your original target mix, you can either sell some of your winners and plow that money into your trailing asset class, or just buy enough of the trailing asset class to return your portfolio to its original target mix.
The do-it-yourselfer has only to figure out how much of a particular asset class to sell to get back to the desired mix. The investor must also decide which investment to sell.
That can be tough. David Martin, a portfolio manager at Stonegate Private Counsel in Halifax, acknowledges that some investors are reluctant to sell any of their winners. "Some people don't want to trim the roses," he says. "But in the long term, rebalancing pays off."
'Over time, asset classes that go up, continue rising for some time. So if you rebalance too frequently, you risk cutting off that momentum effect'—Dan Hallett, HighView Financial Group
Remember that selling investments in non-registered accounts can often have tax implications, so these should be kept in mind. For tax-sheltered RRSP and RRIF accounts, obviously, this isn't an issue.
Investors who use financial advisers should ask their adviser about rebalancing at their annual reviews.
They may find that rebalancing is already being done for them. Most balanced mutual funds — which contain a mix of equities and bonds and perhaps a bit of cash — feature periodic rebalancing. They've proven to be a popular destination for investors' money. The latest data from the Investment Funds Institute of Canada shows $261 billion invested in balanced funds — 42 per cent of the total money invested in funds.
Investors should be aware that many of these funds have fees that eat up more than two per cent of their returns annually — an important consideration when a significant portion of the fund is invested in what are now low-returning bonds.
Many advisers have also placed their clients in managed portfolios — often called "wrap" accounts — that are made up of other mutual funds. These "funds of funds" usually feature an automatic quarterly or semi-annual rebalancing process. But these wrap products have fees that are in addition to the fees imposed by the underlying funds they're invested in. Purchasing the underlying funds directly and having your adviser do the rebalancing is cheaper.
It's even cheaper to buy a mix of exchange-traded funds or low-cost index funds and do the rebalancing yourself. For do-it-yourselfers, some mutual funds also offer cheaper versions of their funds that strip out the adviser compensation part of the fee.
When to rebalance
Many portfolio managers have set percentage thresholds for rebalancing, rather than arbitrary time periods. So once the equity portion of the portfolio has deviated by — five, 10 or 20 per cent from the original target — that would trigger a rebalancing.
Many of the experts we talked to suggest at least an annual review of your portfolio to see whether it would make sense to rebalance. "Once a year, or sooner, if markets have made significant moves up or down," advises Dan Hallett, the director of asset management at Oakville, Ont.-based HighView Financial Group.
But he warns against rebalancing too often. "Over time, asset classes that go up, continue rising for some time," he points out. "So if you rebalance too frequently, you risk cutting off that momentum effect."
KCM Wealth Management's Adrian Mastracci puts it succinctly: "Monthly rebalancing is overkill."
More frequent rebalancing doesn't add more value, adds Warren MacKenzie of Weigh House Investor Services. "The evidence shows that over the longer term, it does not make much difference whether you rebalance quarterly or annually," he says.
The most important thing is to have a written asset allocation and rebalancing plan in place, MacKenzie says, "because without a written plan, you will find a reason to deviate."
Some people claim that rebalancing produces better returns, because people end up selling the out-performing asset class and buying the under-performing asset class. In reality, the verdict isn't as clear cut. Certainly there are occasions when rebalancing has resulted in financial gains. But several studies show there are times when it has reduced returns as well.
"[Rebalancing] is a risk control measure; making sure the asset mix isn't too far away from what the investor is comfortable with," says HighView's Dan Hallett. "It's not a long-term return enhancer."
What a regular scheduled rebalancing can do is to take some of the emotion out of buying and selling. Research in behavioural economics show that investors can often be their own worst enemies.
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