Last Updated on September 1, 2020 at 11:40 am
Portfolio folio rebalancing is like a “system reset”. It is used to remove money from a well-performing asset class (eg equity) and move it to another asset class (eg. fixed income). Investors have many questions regarding this essential portfolio management activity and one of them is: “should I use the best performing mutual fund to rebalance my portfolio, or should I use the worst?”. Let us discuss solutions to this question.
Regular readers may be aware that have discussed many aspects of rebalancing a portfolio. So we shall cover the essential here and provide references to earlier work. What is portfolio rebalancing? To understand this, we must first understand what is asset allocation.
Since all investing is done for future needs, asset allocation refers to the amount of equity and the amount of fixed-income required for a future goal. For example, if you consider a 20-year goal, an exposure of 50-60% equity and rest in fixed income is one way to choose.
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The problem of many investors is, they would have started equity investing late and most of their money would be locked in fixed income like EPF and it would take them years to build significant equity exposure. There is not much choice for them other than gradually, but briskly increase the equity allocation – either using available fixed-income investments or by investing more in equity. This article is not meant for such investors.
Now suppose you have built a portfolio with 50% equity and 50% fixed income. A year later, the allocation deviates because of market movements to say 60% equity and 40% fixed income. You need to shift 10% of equity to fixed income. This is portfolio rebalancing. You can see further examples here: How to Rebalance Your Investment Portfolio.
In case you wondering if this optional, it is not. See: Forget tax and exit loads, this is why your portfolio should be rebalanced each year. In case you are wondering if this rebalancing can be done by changing the amount invested, it is not – at least not beyond a couple of years. This kind of thinking is similar to “I don’t want to move to a higher tax slab because that means paying more tax”! We need to think long-term, think like a rich person, assume our wealth is going to grow much more than we invest and then learn to manage risk.
Rebalancing is not profit booking. In the above example, 10% had to be moved from equity to debt to reduce risk. Mutual funds or stocks, when you sell, the amount will always have gains and principal mixed and is impossible to separate. So it is important not to think of it as profit booking.
Now, the question is, how should that 10% shift be executed. Should we redeem from our best performing funds (or stocks) or the worst? To answer this, it is important to recognise that rebalancing essentially means we remove money from a well-performing asset class to another asset class. In some cases, the destination asset class might be ‘down’.
Thus rebalancing requires maturity to move from a ‘winner’ to a mediocre asset class. Overcoming this mental block is not so easy but certainly possible. We need to get emotional about our future requirement and not think in terms of current returns. We need to recognise that winners do not last and it is important to ‘quit when ahead’. Ideally, one asset class should ‘up’ and another ‘down’ but this is not possible in real life and it is best not to expect it.
The first time an investor has to rebalance, this best fund/stock or worst fund/stock problem is easy to solve. Typically most investor portfolios are cluttered with one fund/stock too many. So for this kind of portfolio first some planning is necessary.
What kind of funds should I hold for a well-diversified but minimalist portfolio? What funds can I remove? In the case of a stock portfolio, “what kind of sector and market cap diversification is best suited for me and what should stocks be removed to achieve this?”.
Once this is understood, any fund or stock that is considered unnecessary can be fully eliminated – that is, sell them, invest in fixed income and/or reinvest in equity as per the target asset allocation.
Just to be clear, if you are holding multiple funds or stocks of the same type, eliminate some of them while rebalancing. In this worst or best fund is irrelevant. The best performer is not necessary for the portfolio (because of duplication) will have to go.
What about the worst performer necessary to the portfolio? This now becomes outside the purview of rebalancing. If you are not going to retain your worst MFs or stocks (in the hope of a turnaround), you will have to replace them with another from the same category.
Remember: portfolio rebalancing and portfolio review are in general two distinct activities. Sometimes you can combine the two but not always.
Portfolio review here refers to evaluating the performance of each fund or stock. Of course, if you are an index investor this step is largely unnecessary (except when your fund deviates from the index of because of persistent ETF nav-price mismatch)
Now, suppose your portfolio is minimalist to begin with (or after the above operation). Say it has one large cap (LC) fund and one mid cap (MC) fund. How should you remove the 10% to rebalance? In general, if large cap stocks do well, mid cap stocks also do well.
In such a case, you can simply remove 5% from LC and 5% from MC. This will also keep the LC: MC ratio the same. From Feb 2018 to March 2020, the Nifty and Sensex moved up because of a few stocks while the rest of the market moved down. This is when the best or worst fund confusion comes to fore. Since this imbalance is unhealthy let us hope it does not recur often.
Say your LC fund has returned 15% in the last year and your MC fund only -5%. If rebalancing is necessary, then it is best to use the LC fund. Remember rebalancing is a risk reduction strategy and should be done with a goal in mind. If you allow greed to get in the way (eg. why not wait a little longer for more gains), the overall loss could be higher.
How do I know a rebalance is necessary? Should I not do this every year? No. Suppose you start with 50% equity and 50% debt and a year later, it becomes 48% equity, rebalancing can be skipped. You can set a threshold of 5% or 7% or even 10% (if your goals are decades away).
This means unless the equity allocation deviates more than 5% or 7% (either side) you will not rebalance. This will reduce unnecessary confusion and tax/charges. Some investors want to know if they can have return thresholds.
That is, rebalance if an asset class return is, say 5% more than expected. Often this would mean the asset allocation has also deviated from its target. Since returns are a poor indicator of portfolio growth and risk, it would be better to stick to asset allocation as a signal. This would help us think in terms of how close we are to the corpus required.
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