VIEWPOINT: Why Bother Rebalancing?
The sixth video in our Proteus Viewpoint video series, Rebalancing: Don't Let the Market Dictate Your Asset Mix
For further information, read the below Q&A.
What is rebalancing?
Rebalancing is the process of returning the overall investment allocation in an asset mix back to the pre-specified target as it deviates with market fluctuations.
For example, an initial target of 20% Canadian Equity and 40% Foreign equity may fluctuate if the Canadian market drops, which could potentially cause the mix to change to a 16% Canadian Equity and 44% Foreign (for example).
Why do you need to rebalance?
Rebalancing all comes back to the need for diversification. Different asset classes behave in different ways and are exposed to different risks. The lack of correlation between the different asset classes benefits investors by reducing the volatility of the total investment portfolio, which provides a smoother path for returns. If you don’t rebalance the mix of the return, volatility will end up being different than what you had planned for when you set up the targets in the first place.
As the asset mix moves, selling part of the asset class that has done well and buying the underperforming asset class brings the weights back in line.
We are not trying to time things. The two approaches we have mentioned are meant to remove a lot of the subjectivity and emotion from the decision.
What makes a good rebalancing policy and what are best practices?
A few things need to be considered when figuring out a rebalancing policy but like anything with investing, it’s all about the risk and return trade-off. The basic idea, as discussed, is that rebalancing reduces the additional or unanticipated risk that comes from a drift in the asset class weights away from the target allocation. But because of transaction costs you can’t rebalance every day or you’re going to end costing the portfolio more in fees than the benefit you’ll get, so middle ground between the cost and the benefit.
How do I balance the cost and the benefit?
There are two broad ways to do efficient, effective rebalancing.
First, you can implement periodic rebalancing, quarterly or annually (for example), where asset classes are moved back to the target weights at regular intervals.
The second approach is to create a tolerance band around the target weights, so rebalancing occurs whenever an asset class moves beyond a predetermined tolerance band (5 per cent, for example).
With periodic rebalancing, you many end up incurring transaction costs even if the asset classes are very close to the target. On the other hand, using a tolerance band is an objective approach to get back to the target weights, as your action is a reaction to market conditions.
What is the best rebalancing policy?
Bottom line, there is not a ‘one size fits all’ and as with most decisions that boards and committees must make, you’ll have to use your judgement and good objective advice to make the prudent decision best for you.
Proteus can help you objectively determine the best approach for your fund. Contact us today!