Rebalancing: An Extra Half Percent

A well-diversified portfolio fluctuates less in value and yields more. In order for a portfolio to not only be diversified at the beginning, but also to be able to exploit all of its advantages over time, it needs regular adjustment – so-called rebalancing.

Rebalancing is so important that we at True Wealth carry out around 40 trades a year in each of our clients' portfolios – fully automatically and at no extra cost.

Diversifying only at the beginning is not enough

When you create a portfolio, you first define strategic guidelines. Based on your personal risk tolerance and investment horizon, you then determine the asset allocation. This requires determining what proportion of your assets you want to hold in which asset classes. In other words, what percentage, for example, in shares, bonds, commodities or real estate.

In the course of time, however, your portfolio does not stick to the initial allocation you have specified. This is because the prices develop differently. Let's take a quick look at this with an example.

Let's assume you invest 100'000 francs and decide on the following asset allocation: 45 percent equities, 45 percent bonds, 5 percent real estate and 5 percent commodities. Then your portfolio looks like this today:

In six months, the shares will have shifted. For our example, let's assume that the stock market has performed exceptionally well with a 20 percent increase in prices, and all other investments have gained a moderate 2 percent each. This would then be your new asset allocation:

The shares of real estate and commodities are now just under 5 percent of the total portfolio. The balance between equities and bonds has shifted significantly.

Rebalancing against shifts

To refresh and restore the planned proportions, the following rebalancing is necessary: You sell shares for 4'455 francs. With the proceeds you buy bonds for 3'645 francs. You also buy real estate and commodities for 405 francs each. Afterwards, the portfolio looks as follows:

The rebalancing already needs four trades in this simplified example. However, a well-diversified portfolio doesn't just contain four investment instruments – but many more (The portfolios of our clients consist on average of 8 to 30 individual ETFs, depending on the risk profile. Rebalancing requires around 40 such balancing trades per year).

Why do we do this?

Rebalancing maintains the effect of diversification over time. It also frees the mind from those all-too-human traps. This is how the following three advantages come about:

• Better returns
• Fewer fluctuations
• Clear rules

Advantage 1: Better returns

If you want returns, you have to take on risk. But if you diversify, you can get the maximum return with a minimum of risk. Rebalancing ensures that diversification is maintained over time and can work as initially planned (You can read about why diversification is so important and how it works in our contribution: «Put all your Eggs in one Basket: Diversification»).

David Swensen, one of the best portfolio managers in the world and currently Chief Investment Officer at Yale University in the US, puts the advantage at 0.4 percent. This is how much additional return rebalancing can bring on a yearly basis (Read more about it in his book: «Unconventional Success»).

Advantage 2: Fewer fluctuations

With the return from the asset classes that have performed better, rebalancing buys in what has performed less well. This compensates for fluctuations.

Fluctuations in value cannot be completely avoided. If you want more return than is possible with a risk-free money market investment, you have to take on risk. But it is better to achieve the excess return with fewer fluctuations. How well this works in a portfolio is measured with the Sharpe ratio.

Our colleagues at the American robo-advisor Wealthfront achieve a Sharpe ratio of 0.6 in their client portfolios. An investment in the S&P 500 index only achieves a Sharpe ratio of 0.43 percent. The diversified portfolios thus perform 40 percent better than pure equity investments.

But this is only possible if diversification is consistently maintained.

Advantage 3: Clear rules

Rebalancing the portfolio follows clear rules. The strategically determined proportions of the asset classes are restored. This objective is clear, and is achieved with every rebalancing.

There are various methods for when and how rebalancing is carried out. If you carry out the rebalancing yourself, you make your choice beforehand – and then act according to your rules.

Professional investors usually carry out rebalancing according to the following rules:

At fixed times. Here you define in advance when the portfolio is to be rebalanced. For example, each client portfolio is rebalanced to the strategic distribution every six months.

At fixed threshold values. Here you define by how many percent an asset class may deviate from its target value. If a maximum of five percent deviation is allowed and the share of equities has risen from 45 to 51 percent, this increase forces an immediate rebalancing – even if the last rebalancing was not so long ago.

Whether at fixed points in time or according to fixed thresholds: When rebalancing, one always acts countercyclically. If shares have fallen, the increased proportion of bonds finances the purchase of additional shares that are now cheaper. Those who rely on rebalancing don't need to live in fear of a crash. On the contrary, they use the correction on the stock market as an opportunity.

Rebalancing included

Listing all these advantages makes it clear: Rebalancing is important. So much so that no portfolio should be managed without it. However, if you manage your portfolio yourself and pay transaction fees for each trade, you may forgo the necessary rebalancing. After all, 40 trades cost around 2'000 Swiss francs even with the cheapest online Swiss brokers.

What we think: Rebalancing is a must. That's why we carry it out for you fully automatically, without you having to do a thing. All transactions are already included in the asset management fee of 0.25-0.5 percent (brokerage fees charged to you by the account-holding bank are deducted from our management fee, see here).

We have developed a rebalancing algorithm especially for this purpose. It automatically keeps your portfolio on track and transaction costs low. We do this according to threshold values: The deviations from your investment strategy are usually less than two percent.

You can see how well this works in your portfolio – or you can simply try it out with a virtual test account.

Links

• Felix Niederer: «Put all your Eggs in one Basket: Diversification»
• David F. Swensen: «Unconventional Success – A Fundamental Approach to Personal Investment» New York, Simon and Schuster, 2005
• Elizabeth MacBride: «The Benefits of Diversification» 
• Oliver Herren: «Wealth management: Even cheaper than trading yourself»
  

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