How effective is portfolio rebalancing?
Asset allocation is THE major decision in deciding your portfolio's returns. Once you decide on asset allocation, it is really important to continuously manage your portfolio. Portfolio rebalancing is one of the most important parts of this. The two main benefits of portfolio rebalancing are:
- Manage portfolio risk - your portfolio will "drift" from your target allocation due to market movements. To bring the portfolio back within the target asset allocation will help manage risk;
- Bonus returns - in rebalancing a portfolio, you generally buy low and sell high. The discipline provides extra returns to your portfolio.
I will take you through BetterWealth's framework of creating a rebalancing strategy. Then show you the risk / return impacts of three types of rebalancing strategies.
BetterWealth's Portfolio Rebalancing Framework
There are lots of methods to rebalance a portfolio. There is no magic bullet. Every portfolio will have a slightly different method that works best. At BetterWealth we have a framework around rebalancing:
- frequency of "looks" - how often do you look at the portfolio and measure the actual allocation vs the target allocation. You can "look" every day, week, month, quarter, year;
- flex range - how strict will you be in keeping the asset allocation exactly the same as the target allocation. For example, target allocation for Australian shares is 39%, and there is a 5% flex range. A rebalancing event will be triggered if actual allocation is less than 36.5% or more than 41.5%. Essentially, 5% flex range gives you 2.5% either side of the target allocation;
- rebalance range - once you decide to rebalance, how much do you rebalance by? Do you rebalance back to the target allocation or allow for some drift. If the rebalance range is 50%, rebalancing Australin shares from 42% will mean selling down to 40.25%, not to 39%. This reduces the amount of assets to be sold down. This means lower transactions costs in buying underweight assets.
Testing Three Methods of Portfolio Rebalancing
Let's have a look at three strategies to portfolio rebalancing. Assume a target allocation of 39% Australian shares, 18.2% Global shares, 7.8% Emerging Market shares, 33% Bonds.
The three rebalancing strategies are:
- Yearly Look - 0% Flex and 0% Range - On 30 June each year, we will look at the portfolio's actual vs target allocation. Any assets that are overweight (actual allocation higher than target allocation) will be sold down. We will sell until actual allocation is the same as target allocation. The same applies for underweight assets. For example, if Australian shares' actual allocation was 41%, 2% will be sold to bring it back to 39%
- Quarterly Look - 5% Flex and 0% Range - Once a quarter we will look at the portfolio. If any asset's actual allocation is 2.5% more, or 2.5% less than the target allocation, we will rebalance. Rebalancing will involve buying / selling assets until actual allocation = target allocation. For example, if Australian shares' actual allocation was 42%, then 3% will be sold. But if actual allocation is only 41%, then there will be no rebalancing event
- Daily Look - 5% Flex - 50% Range - Every day we will look at the portfolio. Rebalancing event will be triggered if actual allocation is 2.5% more or 2.5% less than target allocation. In a rebalancing event, we will bring current allocation within 1.25% of the target allocation. If Australian shares is at 42% actual allocation, we will only sell back to 40.25%.
Show me the results
All three methods had a material impact on the risk / return of a portfolio. Let's see what would have happened if the portfolio was held for 10 years between July 05 to Aug 2015.
Compared to not rebalancing at all, each method generated extra returns.
A starting portfolio of $50K on 1 July 2005 that is not rebalanced, would have grown to $96.3K by Aug 2015. Using the yearly rebalancing method, there were bonus returns of 0.26% per year. This is a difference of $2,400 over the 10 years.
The Quarterly method provided an extra 0.44% per year, or adding $4,000 to the portfolio. The Daily method added 0.28% per year or $2,500 to the end balance.
Whilst this sound like much, the portfolio's target return is only 6.7%. Adding 0.3% to 0.4% is like adding 5% more to the base line return.
These returns includes the cost of buying / selling shares at $15 per trade, but does not include CGT.
Managing portfolio risks
We can look at risk in two ways. How many days were assets in the portfolio outside of the flex range of 5%? What was the volatility of the portfolio (measured by standard deviation)?
A portfolio without any rebalancing would have assets outside of the 5% flex range on 84% of the time (2,137 days out of 2,552 stock market trading days).
The yearly rebalancing method would improve this to 42% of the time. Whilst quarterly method would be 18% of the time. Daily method being 1.1% of the time.
For maths geeks, the standard deviation of the portfolio without rebalancing is 8.14%. All three methods lowered volatility. 8.06% under the yearly method, 8.02% under the quarterly method and 7.99% under the daily method.
How to take action and rebalance your portfolio
Our back-testing shows the benefits of rebalancing in creating extra returns and lowering risks. To start rebalancing your own portfolio, you need to:
- decide how frequently you want to look at your actual allocation. This can be a time draining process every time you "look". You can set up calendar reminders for yourself to "look";
- decide what flex range you are comfortable with. Industry folks generally use 5% flex range;
- decide your rebalance range;
- every time your reminder pings you, do some maths to compare actual vs target allocation.
There is another, easier way. Sign-up to BetterWealth and use our automated portfolio rebalancing tool. We will automatically alert you when to rebalance. You can decide which method you like, or use our recommended approach. Sign-up here to get access when we launch.