Rebalancing in times like these

People around the world are becoming familiar with the phrase flatten the curve. It’s being used to describe the goal of spreading the number of coronavirus cases out over a longer timeframe, so we don’t run out of hospital beds and overload our medical system. To thwart contagion, governments are rightly putting limits on social gatherings, dining out and other events. This, of course, is not good for the economy, as flattening the curve requires measures that keep consumers from spending at normal levels, which, in turn, is causing stocks to be volatile.

How long will consumption be put on pause? It’s uncertain. To combat economic hardships caused by the virus, governments have rolled out wartime-sized stimulus packages to help displaced workers and businesses. In fact, there is enough planned stimulus that some economists are already starting to discuss potential inflation once the economy gets back on its feet. Indeed, uncertainty has landed on our doorstep.

It’s likely that the large market drops experienced in March have pushed your clients’ asset allocations away from their investment policy allocations to something more conservative. For example, take a simple balanced portfolio of 60% MSCI World Index, representing international equities, and 40% Bloomberg Barclays Canada Aggregate Index, representing Canadian bonds. Between December 31, 2019 and March 23, 2020, when the market hit its year-to-date low, the MSCI World Index had fallen 23% while the Bloomberg Barclays Canada Aggregate Index had risen 2%. A balanced portfolio that was at policy at the end of 2019,  and drifting since, would have had an allocation of 53% MSCI World Index and 47% Bloomberg Barclays Canada Aggregate Index on March 31, 2020. While the markets have recovered somewhat since, the portfolio is likely to still be off policy weights. Should it be rebalanced back to target and what implications does rebalancing have on returns?

There’s a classic paper written by Perold and Sharpe in 19881 that discusses the impact of three prominent rebalancing strategies: buy-and-hold, rebalancing to fixed weights and maintaining a constant proportion of portfolio insurance. One interesting point Perold and Sharpe make is that in trending markets (going up or going down), buy-and-hold outperforms rebalancing to a fixed mix. In falling markets such as those we’ve recently experienced, not rebalancing creates a floor—on how far the portfolio can fall—that is equal to the value of non-risky assets in the portfolio. If the portfolio is rebalanced, with more wealth put into equity, and markets continue to fall, then the rebalanced portfolio will do worse than the portfolio that was not rebalanced.

However, we should keep in mind that markets do not trend in the same direction forever. In fact, historically, rebalancing to fixed weights causes one to sell equities and buy bonds. For this reason, your portfolio has likely fallen less this year than had you not been rebalancing over the past 10 years. Additionally, also keep in mind that over long histories, stocks have outperformed bonds, with some of the best returns on stocks following large market drawdowns.

Considering this, what’s the right decision regarding rebalancing?

First, we’d recommend reviewing your client’s situation. If your client cannot afford to lose more money due to a deteriorated situation, then it’s time to refresh their strategic policy and align it with the client’s capacity and tolerance for risk. But in doing this, beware of shifting risk tolerances – the tendency for investors to become more risk averse in the face of unfavorable markets. Shifting risk tolerances that naturally occur with good and bad markets can cause investors to buy high and sell low.

Second, if your client’s policy is correct, then we’d consider that policy as the starting point for the next decision, below. Most investors set their policy allocation according to a risk tolerance questionnaire that maps into a constant mix strategy—a strategy that implies rebalancing to fixed weights at regular intervals. In fact, constant mix strategies are so common that many people treat them synonymously with strategic policies. Allowing a client’s portfolio to drift too far away from their policy allocation is breaking the linkage between their risk tolerance and strategic asset allocation.

Third, evaluate your assumptions about capital markets over the next 3-6 months. If your view is more pessimistic than the assumptions you formed the strategic policy around, you might consider tactically reducing risk. If your capital market assumptions are more favorable than what you formed your strategic policy around, then you might consider tactically increasing risk relative to the strategic policy. If you don’t have a strong view on the short-term outlook relative to the strategic capital market assumptions you formed the policy around, then rebalancing to the policy that is aligned to your client’s risk tolerance is the right decision. 

Although rebalancing is a straightforward concept, there are some nuances to deciding when and how to rebalance. The simplest approach is to rebalance the portfolio on a particular day of the year or at the end of each month or quarter. A downside of this approach is that the portfolio may stray too far from the policy prior to the rebalance date. Another approach is to use range rebalancingcompare the current allocation to the policy allocation regularly to ensure the portfolio does not drift too far from the policy and the client’s targeted risk level. A common practice is to set a range for how far asset classes should be allowed to drift, and rebalancing when they are outside the range.

In selecting a rebalancing strategy, it’s also important to consider transaction costs, taxes, and/or trading restrictions. During times of market volatility the cost of transacting is high. Investors should avoid frequent rebalancing that causes large frequent transaction costs. One needs to balance keeping the portfolio in the right risk range with the cost of doing so.

Bottom line

Markets are volatile because there is a high degree of uncertainty regarding the near-term direction of the economy, federal stimulus, how consumers will react and the path of the virus. Even experts are struggling to forecast with clarity. If you haven’t rebalanced your clients’ portfolios for a while, then it’s likely they’ve drifted away from their policy. And leaving the portfolios as they have drifted is a decision; the decision to rebalance the portfolio must be made. Markets may go lower. But it’s likely that a few years from now, equity markets may be higher. Make sure you consider the options most appropriate for your clients’ situations.


1http://web.stanford.edu/class/msande348/papers/PeroldSharpe.pdf

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