Rebalance? How? When?

“Contrarian strategies [rebalancing] will outperform buy-and-hold strategies in markets that experience frequent reversals (so-called sideways markets). [The] rationale for frequent rebalancing is a belief that markets in the future will tend to move sideways more often than they trend.” Susan Trammell, Nov/Dec 2011, ‘Adaptive Asset Allocation’, CFA Magazine, Vol. 22, No. 6: 47-49.

Sideways Markets experience frequent reversals in direction. They have been called mean-reverting (as opposed to trending like a bull or bear). Isn’t that the type of market that investors have been experiencing? Sound familiar? It should. Seasoned Investors have seen this before.

Well, a sideways market is near perfect for rebalancing because rebalancing captures market ebb & blow before reversal to the mean tendency. Buying low; selling high. And rebalancing has the added benefit of making a volatile (and emotional) investment environment … boring. Boring is good.

The challenge for Individual Investors is how and when to rebalance.

The General Theory.

Absolute risk is addressed through asset allocation. But rebalancing an investment portfolio helps to maintain this long-term policy mix. Simply by rebalancing the investor can execute the policy allocations by returning a portfolio to its policy mix. So rebalancing helps to ensure investor-appropriate balance between risk and expected return. It’s more about risk management than return enhancing. However, investors shouldn’t be surprised if rebalancing adds value especially in significantly volatile and sideways markets. The method and frequency of rebalancing are important but even more important is to not let the portfolio drift to far from policy allocation.

The research studies hypothesize over bands, intervals and tolerances that range from 1% to 20% around the policy asset mix but most studies conclude that when considering risk, return & costs associated with rebalancing, that a 5% band is optimal. In other words, once an asset class drifts more than 5% from its policy mix, then it’s time to rebalance. 5% off policy is the rebalancing trigger. (Even simple market movements will cause a portfolio to drift away from policy).

The many rebalancing studies further show the advantages and disadvantages of the different flavours of rebalancing like calendar, percentage, absolute dollar and periodic cash flow rebalancing. Institutional Investors can get complicated with fancy overlays and asset class deviation intervals, and some even practice hi-tech, daily rebalancing. But many Institutions simply rebalance as part of their regular in/out cash flows.

Individual Investor Implementation

A combined approach of adopting a 5% band to compliment cash flow and calendar rebalancing may make sense for many Individual Investors (especially registered RRSP investors).

If cash is pouring into the portfolio (We all wish!) from interest, dividends, lump-sum periodic contributions etc., then a portfolio needs more frequent rebalancing. All that spare cash needs managing. Un-invested cash is not productive. Cash ‘leakage’ doesn’t earn any (or much) interest. (When rates are high, the opportunity cost is high. But when rates are low, it’s arguably even more important to not have idle cash). This can be a risk for disciplined ‘DCA’ types who have periodic cash inflows but also for those investors that have the bulk of their investments in their registered accounts … their RRSP. RRSPs have cash flow events either in a single lump sum at the outset of each New Year or in several lumps throughout the year or (for the more disciplined) in monthly inflows. Again, idle cash is a drag on performance.

Regardless of the rebalancing approach, investors should consider that rebalancing works best if the markets are moving sideways (up down up down versus trending) AND the more volatile the markets the better. So the last several months have been near perfect for rebalancing. In fact with stock markets up/down 2% – 4% daily, and with bonds at uber-lows (Long Canadas @ 2.53% this morning), represents more than a ‘risk-management’ opportunity … It’s just as much a return capture opportunity.

Individual investors are somewhat constrained with rebalancing, however, because of the size of their portfolios. One doesn’t want to be rebalancing with small or odd lot purchase/sales. One doesn’t want to be ‘tinkering’. Remember, asset allocation is a blunt instrument. (Think ‘ballpark’). Moving back ‘towards’ the policy mix is a step in the right direction.

Buy Low and Sell High

Rebalancing helps force the buy low; sell high decision(s). Investors tend to hang on to winners (too long) and not buy what is losing (undervalued). But rebalancing helps move beyond the emotions around the buy low and sell high decisions.

See Buy Low and Sell High made Easy.

Market volatility got you down … then up, then down again? The best defence is a rebalancing discipline.

Next time?

Risk Management.

Doug Cronk CFA is Manager Investments for a Canadian Pension Plan