Time To Rebalance Your Portfolio
When you start the process of portfolio construction it is important for you to understand the reason why you are investing and the purpose or the goal the portfolio will try to achieve. It will help you to decide on various aspects of portfolio management, including its rebalancing strategy. The article shows how you can go about the rebalancing exercise
The Indian equity market represented by Nifty is currently trading at an all-time high of 17,600 as of September 16, 2021, up by almost 25 per cent year till date. The mid-cap and small-cap indices in the same period are up by 41 per cent and 52 per cent, respectively, in the same period. From its low of March 23, 2020, Nifty and mid-cap indices have more than doubled while the small-cap index has grown three-fold.
Equity mutual fund investors are no doubt surprised and awed by returns that have not been witnessed in the last one decade. In the short span of one and half years, on an average the equity-dedicated mutual funds have generated return of 72 per cent. There are categories that have generated returns in triple digits. Mutual funds dedicated to the IT sector and small-cap have generated returns of 120 per cent and 106 per cent, respectively.
Further, despite such a rise in the indices and massive gain in equity funds, we have not seen any meaningful correction. The largest drawdown that we have seen in the equity market since the start of the financial year 2021 is 8.5 per cent between February 16, 2021 and April 20, 2021.
On an average, we have a correction of around 10 per cent every year in the stock market barring a couple of years like 2014 and 2017. Nevertheless, after these years we saw a deep correction in the consecutive years. For example, in 2015 we saw a correction of 15 per cent and in 2018 we saw the Sensex correcting by more than 10 per cent from its peak twice. Even during one of the best bull phases of 2004 and 2007 we saw correction of more than 10 per cent every year. In 2005 and 2007 we saw correction of more than 10 per cent twice.
Market Conditions for Correction
Correction in the equity market does not mean the dawn of a bear market. A bull market correction is a correction of typically 10 per cent or so. In a bull market correction there is very little change in the fundamentals of the economy or companies but the market is a bit ahead of the wave. It is possible that there is a euphoric mood in the stock market which builds up gradually and it can last much longer than a period of extreme fear. A period of euphoria need not be followed by a sharp correction. If the fundamentals remain good, there is often a correction in time.
Prices then stand still and sometimes move sideways for a long time. Now, let’s gauge through various matrices if the market has moved ahead the fundamentals as we are sure that we are not seeing any bear market correction. The chart presented below of India’s valuation index sourced from Axis Securities is calculated based on four fundamental market parameters – 12- month forward PE, 12-month forward PB, bond equity earnings yield ratio and m-cap to GDP ratio. It shows that the Indian market valuation index has retraced to the caution zone after the recent run-up. Last time we saw such an elevated level of valuation was in 2007.
Even we take some other equity market valuation parameters the indication is that caution is warranted.
All the above figures are for month ending August 2021. After that the market has gained almost 3 per cent, which makes the valuation even more stretched. Historically, we have seen there is a bit of either time correction or price correction after the market reaches such higher valuation. The reality is, however, that more money is lost in predicting a correction than in the correction itself. Anecdotal evidence suggests that many institutional investors announced they had protected themselves against further price falls by going massively short on futures at the bottom of 2003. Even in the Indian context we saw that last year in the month of September many analysts were arguing about the stretched valuation and imminent fall in the market.
Nevertheless, the market is up by almost 50 per cent from the lows of September. Every investor is human and should be aware of these emotions. Therefore, the best way to deal with such a situation is to decide in advance what is rationally sensible in such a situation and act accordingly. For example, if you are a conservative investor and do not want to take much risk or are not very comfortable with large drawdown, it is better to rebalance your portfolio at an appropriate time and reset it to the original asset allocation, which is better known as rebalancing.
Types of Rebalancing
When you start the process of portfolio construction it is important for you to understand the reason why you are investing and the purpose or the goal the portfolio will try to achieve. It will help you to decide on various aspects of portfolio management, including its rebalancing strategy. Rebalancing of the portfolio formally addresses the queries of ‘how often, how far and how much’ i.e. how frequently the portfolio should be monitored, how far an asset allocation can be allowed to deviate from its target before it is rebalanced and whether periodic rebalancing should restore a portfolio to its target or to a close approximation of the target. The clear advantage for any these strategies is that it will help you to maintain the portfolio’s risk-and-return characteristics that you are comfortable with. For example, if you are a conservative investor, any higher weightage of equity portion may increase the riskiness of the entire portfolio if it is not rebalanced at an appropriate time and different assets are restored to their original proportion.
Time-Only Rebalancing
When using the ‘time-only’ strategy, the portfolio is rebalanced every day, month, quarter or year, and so on, regardless of how much or how little the portfolio’s asset allocation has drifted from its target. As the strategy’s name implies, the only variable taken into consideration is time. Determining the frequency with which to rebalance the portfolio largely depends on the investor’s risk tolerance, the correlation of the portfolio’s assets and the costs involved in rebalancing. The figure below shows the results for the time-only rebalancing strategy using several different frequencies i.e. quarterly, annually and never.
The target asset allocation used in the figure is 50 per cent equity-represented Sensex and 50 per cent bonds represented by Clearing Corporation of India (CCIL) Broad TRI whose index consists of top 20 traded bonds. The time period is the start of 2004 through August 2021. The figure assumes that each portfolio is rebalanced at the predetermined interval regardless of the magnitude of deviation from the target asset allocation. As the chart below shows, the yearly rebalanced portfolio tends to perform better than the portfolio that is never balanced.
If we compare the downside risk of the portfolios with different intervals of rebalancing, we find that the portfolio that is rebalanced on a yearly basis has witnessed lower drawdown. The portfolio that is never rebalanced has witnessed maximum drawdown.
The table below shows the performance summary of rebalancing.
The above analysis and its results are only for one period and there could be many other periods where the results would have been different. Hence, the above figures should not be considered as the benchmark of portfolio rebalancing. Thus, the million dollar question is about which frequency is preferred. The answer depends primarily on an investor’s preference – the amount of deviation from the target that the investor is comfortable with as well as the costs the investor is willing to incur given the degree of variation. The number of rebalancing events was significantly higher for quarterly rebalanced than for annually rebalanced portfolios – 204 versus 17 – which would result in higher trading costs for the quarterly rebalanced portfolio along with higher tax as short-term capital gain tax is mostly higher than long-term capital gain tax.
In addition, the quarterly rebalanced portfolio provided lower average annualised return. For the annually rebalanced portfolios this will further come down if we add the cost of rebalancing. The never rebalanced portfolio saw major orientation towards equity by the end of the period to the tune of 84 per cent. Here again, as the portfolio’s equity exposure increased, the portfolio displayed higher risk in terms of higher standard deviation of 15.4 per cent versus 11.32 per cent for the annually rebalanced portfolio and 11.42 per cent for the quarterly balanced portfolio. Even in terms of maximum drawdown the portfolio that was never rebalanced saw maximum drawdown.
Threshold-Only Rebalancing
The second strategy, called ‘threshold-only’, ignores the time aspect of rebalancing. Investors following this strategy rebalance the portfolio only when the portfolio’s asset allocation has drifted from the target asset allocation by a predetermined minimum rebalancing threshold such as 1 per cent, 5 per cent or 10 per cent, regardless of the frequency. The rebalancing events could be as frequent as daily or as infrequent as every five years, depending on the portfolio’s performance relative to its target asset allocation. To analyse the impact of thresholdonly rebalancing strategies, we conducted a historical analysis for the rebalancing thresholds of 5 per cent and 10 per cent, assuming daily monitoring. If the hypothetical portfolio’s allocation drifted beyond the threshold on any given day, it would be rebalanced back to the target allocation.
Again, with this strategy the magnitude of the differences in the average equity allocation, in the average annual return and in the volatility may not warrant the additional costs associated with a 5 per cent threshold of 213 rebalancing events versus a 10 per cent threshold of 76 rebalancing events. The following table shows the performance of both the portfolios that have a threshold of 5 per cent and a portfolio that has a threshold of 10 per cent. There is hardly any difference in the performance of both the portfolios.
Implementing the Strategy
The rebalancing strategy discussed above looks easy to implement. Nevertheless, while translating this conceptual rebalancing framework into practical strategies, it’s important to recognise a few real world limitations. First, there is cost of rebalancing. There are two important costs of rebalancing: first is exit load and second is taxation. Our study of threshold-only strategy shows that it costs around 2 per cent of your portfolio to rebalance once, assuming you are in the highest tax bracket. Besides, investors do not monitor their portfolio regularly and they implement a mix of both time-only and threshold-only strategies while the tolerance level can even cross beyond 20 per cent depending upon the market and macro-economic environment.
One of the best ways to rebalance your portfolio is to use its cash flows. If you have pure equity investment or mutual fund with dividend option you should first exhaust these to rebalance your portfolio and only after this should you consider redeeming and purchasing of the funds for rebalancing your portfolio. From the above discussion we believe it might be the right time to rebalance your portfolio if have higher exposure to broader market funds as they have moved up by more than 40 per cent.
However, if you have more exposure to large-cap funds, you can start monitoring it closely. Going by the current market valuation it also seems to be the right time to rebalance your portfolio, even if you have rebalanced it at the start of the year. On a broader level, annual rebalancing gives you better risk-adjusted return. This is also likely to reduce your cost of rebalancing. Nevertheless, it should be taken with a pinch of salt as our study was for equal weighted portfolio of equity and debt. For different weightages of assets the scenario may change.