Get ready to rebalance

PORTFOLIO POINT: After a volatile time on the market, now is a good time to ensure your equities/bond mix is set correctly.

It’s the start of the year and you’re probably thinking about rebalancing your portfolio. And so you should after such a volatile few years, because now is a great time to revisit this essential task. In fact, after a year in which the market moved ever lower in the first three months and then rebounded by 50% rebalancing makes more sense than ever.

In mid-2008 I explained (see Rebalance and realign your portfolio) the how’s and why’s of rebalancing; essentially it’s all about reducing risk and enhancing reward.

While this example concentrates on keeping your critical, overall equity-bond mix in check, the same principles can be applied a step down to control your exposures to various sectors (such as banks and resources) and also to large stock holdings (BHP, perhaps).

Recent Australian equity and bond returns

The five years to the end of 2009 was an exceptional period for both equity and bond returns. The extreme volatility and divergence of returns between these main asset classes is why rebalancing, or lack of it, made a big difference. The figure below shows first of all how investments separately in shares (including and excluding dividends) and bonds fared during that time.

Following boom, bust and the recovery to date, $1 million invested in Australian shares at the start of 2005 was worth at its peak $1.87 million in late 2007. It then fell to just below $1 million to later recover to $1.49 – or about where it was two years ago, assuming you include dividends.

Note the popular press fondly report the price only of Australian shares, either in aggregate as an index or individually. On a price-only basis, your $1 million original investment would appear to have grown to a lesser $1.67, be cut in half to $810,000, then recover to a more modest $1.19 million. If you follow media reports and roadside billboards of share prices only, you will be disappointed and misled about the true rewards for putting your capital at risk.

Over a separate boring, boom and back (as in “They’re back” or no longer boring) cycle, a $1 million investment in the broader Australian bond market would have grown to $1.33 million for the five years to December 31, 2009.

Initially Australian bonds offered a steady return of about 5% annually to July 2008. At that time, concerns about the severity of the financial crisis rose and investors began to “appreciate” bonds.

In the six months to January 2009, money invested in the broader bond market grew by 12% (equivalent to a massive 23% annual return) while cash rates plummeted to 3%. The divergence between bonds and cash taught many an important lesson about the differences between these two cousins of fixed interest investing.

Unbalanced portfolio returns

Investors don’t invest only in equities or bonds; generally they invest in both so as to balance eating well with sleeping well. The below figure shows how a $1 million portfolio initially divided equally between Australian shares and Australian bonds fared over this rollercoaster five-year period.

This portfolio was not actively rebalanced. In effect, $500,000 was invested in a basket of dividend reinvesting shares or funds for the period, and a separate $500,000 compounded in bonds, a cash account or as rolled over term deposits. This hands off or segregated approach to portfolio management is quite common.

Over this time period this combined $1 million grew to a peak value of $1.5 million plummeted $360,000 to a low of $1.14 million and then recovered to $1.41 million.

While this portfolio started out balanced, at its peak it was 63% invested in equities – 13% above its initial target range. Following the collapse of equity prices and rise in bond prices, the proportion invested in equities swung to a low of 43%, or 7% below target.

These unmanaged swings in returns would have caused great consternation to any investor, requiring either ostrich-style head-in-the-sand monitoring or, worse, could have provoked abandoning equities at the wrong time.

Rebalanced portfolio returns

Rebalancing is primarily about controlling risk in your portfolio, specifically the risk of having too much or too little equities. It generally requires you to sell down equities after they have performed well and buy more when they haven’t. Although this sounds counter-intuitive, in volatile times it fosters a profitable “sell high”, “buy low” discipline.

The below figure shows, using the superimposed blue curve, how this same initial 50:50 equity:bond portfolio performed if rebalanced once a year. Specifically each January equities or bonds were sold in sufficient proportion to bring the portfolio back to a 50:50 mix. The transactions required are noted in “cautionary orange”, where equities were sold and reinvested in bonds, and in “profitable green” where the reverse occurred.

Because equity markets rose further than bonds in all calendar years except 2008, four of the five rebalancing transactions involved selling equities and buying bonds – between $42,000 and $109,000 in amount. This had the effect of derisking the portfolio, each time pulling down the rising equity bond mix back to 50%. However, in January 2009 $193,000 was taken from bond reserves and reinvested in equities. Although it was a brave step at the time, this is less than the combined $252,000 transferred into bonds from equities from the four other rebalances. It is vital to take note that the signal to reinvest was not predicated by a conviction the market was ripe for recovery, but by the portfolio not having enough equities.

Until about mid-2008, the rebalanced portfolio slightly underperformed the unmanaged portfolio. However, as the market declined further, this portfolio fell less. It recovered faster when the extra money put into bonds was taken back and reinvested near the bottom of the market. This enabled the rebalanced portfolio to finish the decade at an all-time high $40,000 above its earlier peak, just in time to celebrate the new decade!

Specifically, the rebalanced portfolio grew to $1.51 million by close of 2009 compared to $1.41 million for the unmanaged portfolio. This corresponds to a compounded annual return of 8.6% versus 7.1%. The 1.4% per annum gross return improvement equalled $100,000 or 10% of the original investment. Normally the difference wouldn’t be so high, but these were not normal times.

From a risk or volatility perspective, the rebalanced portfolio fell peak-to-trough by $270,000, a smaller fall than the $360,000 of the unmanaged portfolio. A rebalancing strategy doesn’t set out to eliminate all risk but it can take away some fear. Perhaps this, along with having a disciplined buy/sell strategy to practice when all hell broke out, was enough to avoid triggering a potentially expensive flight to cash.

Rebalancing mechanics

Having established that rebalancing may lower risk AND improve return, it is worth commenting further on the nuances of rebalancing.

The table below summarises key outcomes from different rebalancing strategies. While all approaches improved both risk (as measured by peak-trough collapse) and return (as measured by final value), when and how you rebalance brings different results.

The variation, depending on which month you annually rebalanced, is driven by luck. January was superior because you would have reduced equities shortly after the November 2007 decline, bought back in two months before the March 2009 rise and let profits run to the end of 2009. I prefer to rebalance twice annually, often around January and July, as these periods align with significant cash inflow and outflow events. This reduces the risk of picking the wrong month if you only rebalance annually.

An alternative approach to rebalancing on a calendar basis is to do it only when your portfolio drifts out of range. In the example in the table, that was six times when the proportion of equities rose above 55% and below 45%. This “threshold” approach to rebalancing has its merits, but you might find yourself rebalancing too frequently and at times when you don’t have or need cash – like before receipt of dividends, rent and interest and payment of pensions and tax.

For those worried about bringing forward capital gains tax, in practice many investors need to sell little or no equities in rising equity markets to fund rebalancing as there is often sufficient surplus cash available from income or contributions. While pension investors often need to redeem investments to also fund living, they are generally tax-free investors. In most cases non-tax transaction costs are minimal relative to the benefits as shown.

When you invest in large amounts of illiquid investments such as unlisted property, infrastructure projects, private equity and hedge funds, you may find it difficult to properly take advantage of opportunities to buy oversold assets, as you can’t trim your position in these assets easily. This may have been an issue with some industry funds during the last cycle, which future performance figures might prove out.

This strategy of periodically “taking some equity risk off the table” and reinvesting when times are bleak, works also with higher equity portfolios. An initial $1 million January annually rebalanced, 70% equity higher growth portfolio would have grown to $1.53 million on December 31, 2009 – $90,000 more than an unbalanced portfolio, which would have only grown to $1.44 million.

Note that a 100% Australian equity portfolio would have grown to $1.49 million by December 31, 2009, which is less than a rebalanced portfolio with 30% in what some consider to be lazy bonds. For this reason I often recommend high growth investors (excluding those borrowing to invest) cap the amount of shares in their portfolio at 80%. Otherwise when good buying comes around you don’t have any buffer to borrow from. Many don’t realise that boring old bonds act as performance enhancers during periods of volatility, not just return smoothers.

In this simplified portfolio we are simply balancing a “see-saw” between equities and bonds. While some invest this way (perhaps using term deposits in place of bonds), it is more likely you target investing in multiple asset classes, sectors and companies. If so you should rebalance to the specific targets laid out in your “living” investment policy – not the one you leave unloved in the drawer or with your accountant.

Finally, if you were able to stay invested during the period we’ve just had, you probably have the right stuff to invest anytime. It is possible the next five years will prove far less exciting than the last. Since that’s uncertain, your default position as an investor must be to keep your portfolio on target and not let it drift unmanaged or separate it into non-interacting pots. You should be rewarded for doing so.

Doug Turek is principal adviser with independent advisory firm Professional Wealth Pty Ltd.