Pros And Cons Of Rebalancing A Portfolio
It does not make sense to simply invest available money into all kinds of mutual funds without understanding the objectives of making such investments or choosing the right funds to create a balanced portfolio that can provide the best returns
Investing in stocks or equity mutual funds or even in bonds or debt mutual funds involves risk. And it is crucial on the part of an investor to manage this risk. Most people, though, have a tendency to avoid risk, which is quite impossible when you are investing in such asset classes. Risk is part and parcel of investing even if you are parking your funds in a risk-free government bond. However, you can always manage the risk factor by adopting various tools developed and used over the years by investors around the world. One such tool is rebalancing.
Understanding Rebalancing
The basic concept of portfolio rebalancing, as the name implies, is to realign the balance of investments in a portfolio. This is to stay in accordance with the original target weightings for that portfolio, especially since asset classes can have materially different long-term returns. This is crucial to ensure that the portfolio does not wander to the point of violating an investor’s risk tolerance. For instance, consider for a moment the fact that the long term return on equity mutual funds is about 12 per cent annually while the long term return on debt mutual funds is around 8 per cent. In a portfolio that is allocated 50 per cent towards equity funds and 50 per cent towards Debt Funds and adopts a ‘buy and hold’ strategy, the equity and debt portions will grow at an average of 12 per cent and 8 per cent annually. This means that over time the weightage of equity mutual funds would become larger in the portfolio.
As shown in the above graph, the absence of rebalancing would cause allocation of equity to become larger over time due to the excess returns of equity over debt. What begins as a portfolio of 50 per cent equity and 50 per cent debt drifts to 63 per cent equity and 37 per cent by 15 years and nearly 75 per cent equity and 25 per cent debt after 30 years. Therefore, just buying and Pros And Cons Of Rebalancing A Portfolio It does not make sense to simply invest available money into all kinds of mutual funds without understanding the objectives of making such investments or choosing the right funds to create a balanced portfolio that can provide the best returns holding a portfolio of equity and debt funds will eventually lead the equity exposure to balloon and become far greater than what it originally was and may be greater than what a client can actually tolerate.
Yet, the fact is that keeping equity exposure from drifting too high would mean that the cumulative portfolio returns will actually be reduced by systematic rebalancing and not enhanced. This is because rebalancing would just end up systematically selling the higher-returning asset (equities) to buy more of the lower-returning asset (debt or fixed income), and this drags down the long-term returns. Nonetheless, it also decreases the risk of larger drawdown of the portfolio.
As shown above, the process of rebalancing to prevent equity exposure from drifting higher also curtails the favourable returns that come with allowing equities to compound. The portfolio that starts out at ₹10,000 each in equity mutual funds and debt mutual funds and is annually rebalanced grows only to ₹1.71 lakhs over time compared to the buy and hold strategy without rebalancing in which the portfolio grows to ₹1.78 lakhs. Taking up a case study to understand the benefits of risk management with regards to rebalancing, we note the following. Definitely, a notable caveat of the instances discussed in the earlier paragraphs regarding the impact of rebalancing between equity and debt is that while equity funds may outperform debt funds over time, they rarely ever do so in the exact straight line shown in the above graphs.
Instead, returns from debt funds and especially equity funds are more volatile, presenting the possibility of selling equity funds when they are up and buying bonds when they are down or selling debt funds when they are up to buy equity funds after a crash. This leads to the question about whether or not there is more return given up in the long run by rebalancing out of higher-return equity funds into comparatively lower-return debt funds. In order to understand it in the real sense, we created a portfolio of equity and debt where we assumed Nifty 500 Total Returns Index (TRI) as the representative of equity and short-duration funds as proxy of debt funds.
Case Study
The portfolio that we created dedicates 50 per cent towards equity and 50 per cent towards debt. Further, we assume that you invest ₹10,000 each in Nifty 500 TRI and short-duration funds and back-tested how the portfolio performs with and without rebalancing. For back-testing we took 10 years’ historical data of Nifty 500 TRI and short-duration funds for the period March 2012 to March 2022.
In the above chart, although a rebalanced portfolio scores over the buy and hold portfolio, we can see that there is almost negligible difference between them. Moreover, even if we look at the standard deviation of the annual return generated by these portfolios, then for a rebalanced portfolio it is 14.7 per cent while for a non-rebalanced portfolio it is 15.3 per cent. Therefore, even in terms of risk, rebalancing the portfolio does not seem to be of much help.
As can be seen in the above graph, there is almost no difference in the portfolio with and without rebalancing. Therefore, it makes no sense to have a rebalancing period of over one year. Even in terms of risk, it is almost identical. Thus, as far as risk management is concerned, it does not seem right to have a rebalancing period of over one year.
Conclusion
Rebalancing is a tool which is generally used for risk management and a majority of financial planners across the world recommends investors to do so. Rebalancing is nothing but a process wherein you book profit from the asset class that has surged to invest in another that is beaten down. However, the major concern is whether at all it makes sense to put efforts in rebalancing. In order to understand this, we took a portfolio wherein 50 per cent was in equity (Nifty 500 TRI) and 50 per cent in debt (short-duration funds). Then we invested ₹20,000 in the aforementioned portfolio and carried out two actions – one with rebalancing and one without it.
The outcome of this exercise was that the one with rebalancing performed well as compared to the one without rebalancing. However, the performance was marginally better and even in terms of risk there was no breakthrough difference. Next, we tried rebalancing the same portfolio every two years. This resulted in both rebalancing and non-rebalancing moving in the same fashion. There was almost no difference in their performances. Hence, we can say that if at all you are rebalancing your portfolio, this should be done every year to make it worth the while. The moot question is whether it makes sense to rebalance your portfolio?
Our research and analysis shows that the end result is almost similar with no major outperformance. Therefore, we believe that the buy and hold strategy makes more sense than engaging in systematic rebalancing. However, the biggest advantage of rebalancing is risk management. This is because if you do not rebalance your portfolio, the equity part of your portfolio drifts higher, thereby exposing you to greater risk. Hence, if you are an investor with a conservative to moderate risk profile, rebalancing your portfolio annually makes more sense. But if you are an aggressive to super-aggressive investor, then the buy and hold strategy without rebalancing is what you should opt for.
That said, an even better investing strategy would be to rebalance your portfolio tactically. In the cover story published in our issue of November 2020, we had compared the buy and hold strategy with that of a tactically managed portfolio called the dynamic investment strategy. Interestingly, the study concluded that managing a portfolio tactically leads to greater benefits. Therefore, if your goal is wealth creation in the long term, a dynamic investment strategy will yield better returns. However, if you are planning to achieve specific financial goals, a strategic asset allocation strategy is the way to go.