Here’s How to Rebalance Mutual Fund Portfolio:
Portfolio rebalancing happens to be at the core of portfolio management. It keeps your portfolio from falling prey to market fluctuations.
Just like fine-tuning a guitar, portfolio rebalancing is done to ensure that portfolio parameters remain as per expectations. It involves bringing asset allocations back to the target allocation.
Let’s understand this with an example.
Suppose you have a portfolio of Rs 1 Lakh consisting of stocks, bonds and cash in the ratio of 50:40:10. Accordingly, your investment in stock, bonds, and cash is Rs 50000, Rs 40000 and Rs 10000 respectively.
At the end of one year of investment, the closing balances in equity, bonds, and cash are Rs 70000, Rs 30000 and Rs 11000. You witness stocks and cash rise by 40% and 10% respectively; while bonds fall by 25%. Hence, the portfolio value stands at Rs 111000.
Your asset allocation has changed considerably from 50:40:10 to 63:27:10. It shows that allocation in stocks has increased significantly vis-a-vis earlier scenario.
Ideally, you need to rebalance the portfolio now to maintain risk profile at previous levels. Let’s consider two situations: in the first situation, you rebalance the portfolio. In the second situation, you don’t make changes to the skewed portfolio.
Imagine in the following year; the stocks fall by 10% while bonds and cash rise by 15% and 5%.
The impact on the portfolio will be as shown in the table:
Rebalancing has a positive influence on the portfolio value. As compared to the unbalanced portfolio, rebalanced portfolio increased in value in the following year.
Even though other components of the portfolio experienced a rise, but a higher equity exposure in the unbalanced portfolio nullified such accretions.
Thus, rebalancing helps your returns to stay in line with the expectations. It protects the portfolio value from falling on account of market volatility.
Redemption is done in those securities which have exceeded the target allocation. And then, that money is diverted to purchase those securities which have fallen below the target allocation.
There’s one more point that needs emphasis. Just in case the stocks rise in the following years, the value of unbalanced portfolio may increase more than the rebalanced portfolio.
So, the rationale of rebalancing is more towards reducing the portfolio risks; instead of earning higher returns. You may view this strategy as limiting your upside potential; meanwhile minimising the probability of losses.
How to rebalance a portfolio?
Portfolio rebalancing is critical activity as regards portfolio management. It helps to keep the risk profile of the portfolio as per your preferences.
Investing not only requires determination of a favorable asset allocation; but also a rebalancing strategy.
While designing a rebalancing strategy, you need to decide about the frequency and threshold. Frequency implies “how often you need to rebalance your portfolio.” Threshold suggests “at what level of deviation from the target should you trigger a rebalancing.”
There are primarily three portfolio rebalancing strategies:
In this, you perform rebalancing by a pre-decided time interval. It can be done on a monthly, quarterly, semi-annually or annual basis.
A semi-annual rebalancing strategy would adjust the asset allocation after every six months within the investment duration.
You may refer the following table to understand time-based rebalancing:
You may find that the equity allocation is the highest in annual rebalancing. As the frequency decreases, the portfolio turnover also falls. It means that lesser the rebalancing events, lower the portfolio maintenance costs.
As regards returns, those are higher in quarterly & annual rebalancing.
Your primary concern needs to be about the risk profile of the portfolio. It’s the least in annual frequency. Going by risk-return tradeoff, annual rebalancing seems beneficial; you get a similar return at lower volatility.
In this, you perform rebalancing by a pre-decided threshold. The threshold can be 1%, 5%,10% or any other based on your risk preferences.
In this strategy, irrespective of time, the deviation from the threshold triggers rebalancing. A 5% rebalancing strategy would adjust the asset allocation as soon as it crosses 5% threshold.
The higher the risk appetite, higher would be the threshold and vice-versa.
Time and Threshold-based Rebalancing
In this, you will inspect your portfolio at the pre-decided time interval; the rebalancing will be done only if the allocation has exceeded the threshold.
In a quarterly-5% threshold strategy, you will check your portfolio every three months; and make adjustments only if allocations have gone beyond 5% limit.
Higher thresholds result in relatively higher average equity allocations. It’s because a higher threshold indicates your preference for greater risk-taking.
Frequent rebalancing with lower thresholds would lower your portfolio risk profile. But at the same time, your returns will be affected.
In the table above, you are getting the lowest returns when you rebalance on a monthly basis; with 1% threshold. Accordingly, this strategy is going to be the most expensive one.
Similarly, you are getting the highest return of 8.9% when you rebalance on a quarterly basis; with 10% threshold. Accordingly, this strategy is going to face the highest volatility.
The ideal scenario
The best scenario is when you rebalance annually with a 5% threshold. At the lowest volatility, this strategy gives you the optimum annualized return.
Other Considerations while Rebalancing
1. The cost of rebalancing always needs to be less than the returns earned.
2. Rebalancing would involve the sale of existing units. To reduce tax incidence, annual rebalancing at higher thresholds like 5% is considered better strategy.
3. You may feel emotionally attached to your existing portfolio holdings. Maintain a rational attitude. Keep your goals in mind while rebalancing the portfolio.