Last Updated on February 20, 2022 at 7:59 am
If there is one action that most investors who appreciate asset allocation are hesitant to do, it is probably portfolio rebalancing. On the one side, there is fear of taxes and on the other, uncertainty on how to rebalance and which to sell. In this article, we shall consider some examples of portfolio rebalancing.
Many investors have low equity exposure in their portfolios with most of the money locked away in EPF or PPF. Rebalancing from the safety of debt to equity is not easy (even if technically feasible) and few would come forward. Here is an example: Why I redeemed from EPF to invest in Equity MFs.
We shall not discuss this situation in this article and confine ourselves to those who currently hold significant equity exposure. Among this group, we have heard all sorts of excuses to avoid rebalancing. For example: “I have just started investing. So why should I rebalance?”; “I will gradually adjust my investments and rebalance the portfolio instead of withdrawing?”
The goal of rebalancing is to reduce the volatility in the portfolio return. For example, a 100% portfolio return (XIRR since inception) can swing from say +25% to – 20%. Add some fixed income into this then the swing reduces considerably. Say from +15% to -10%.
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The asset allocation will not remain at the initial values of say 60% equity: 40% fixed income and will keep fluctuating. The higher the deviation from the desired asset allocation, the higher the swing in portfolio (in the case of higher equity allocation). The goal of rebalancing is to reduce this volatility in return by resetting the portfolio back to the desired value. See: Forget tax and exit loads, this is why your portfolio should be rebalanced each year.
Those who are absolute beginners can consult: How to Rebalance Your Investment Portfolio.
But why is this important? Because if year on year fluctuations in portfolio returns are too high, the chance of us getting a return close to what we want is er .. left to chance! Surely our money deserves better respect than this!
Since investing is done for some future use, we cannot maintain the same asset allocation for too long. Goal-based investing requires a steady change in asset allocation. This typically means a reduction in equity allocation. So going from 60% equity to 55% equity is also a form of rebalancing. See:
Trying to accomplish this by changing investment amounts would take too long – several months depending on market movements. During this time, the market could rebalance a portfolio with a good little crash.
I have been investing for my son’s future expenses for more than 12 years now. During this time, I have rebalanced the portfolio twice a year once on two occasions and once on several occasions. This has allowed me to gradually shift the corpus necessary for his college education from equity to debt. See for example This useful feature of PPF deserves more attention! And as an example: I rebalanced my retirement portfolio twice this year thanks to the bull market. Rebalancing has given me the peace of mind that I have enough assets in fixed income to pay his college fee.
So to summarise portfolio rebalancing is a way to immediately reduce portfolio. Adjusting investment amounts will take time and beats the objective of rebalancing. Today social media is dominated by young investors with small portfolios and it is natural that they do not appreciate this. As their portfolio grows in size, this will gradually dawn on them.
Also, rebalancing means removing money from a well-performing asset class and investing it in a relatively poor performing asset class. Only those who can view at risk and reward at the portfolio level can appreciate the need to do this.
Finally, having too many asset classes can complicate rebalancing. For example: equity + debt + gold or Indian equity + international equity + fixed income. Hodling 10% of gold or 20% of US equity is easier announced than done. We recommend keeping asset classes to a minimum for ease of maintenance.
Portfolio Rebalancing Examples
Consider a portfolio with four equity funds A, B, C, D. We will assume the most common rebalancing action of redeeming from equity and investing in debt. The reverse is also important and follows the same logic.
Example 1: All four funds are Indian equity funds. A,B,C are in profit and D is in a loss. This typically happens when one has thematic funds. Partially or fully exit from D to rebalance. There will be no tax burden. This reasoning also applies to decluttering a portfolio.
Example 2: B and C are similar funds. Partially of fully get rid of one of them.
Example 3: A has a maximum weight of 70%. Reduce exposure to A (and therefore concentration risk) by selling some units and shifting the money to fixed income.
Example 4: All funds have more or less similar weights and similar returns. Each fund is unique and has a specific purpose in the portfolio. Then remove from all of them equally!
Example 5: A is the best performer and is the main driver of the overall equity portfolio return. There are two choices here: Follow the momentum and redeem from other funds. This will increase concentration risk in A. Or you can redeem from A fearing the good run would end. Either way, there is no place of regret while rebalancing or for that matter anything associated with the capital markets. Hindsight is always 20-20.
Example 6: I have only two funds: Nifty and Nifty Next 50 (NN50). I am worried about the poor performance of NN50. Most of the equity gains are from Nifty. If you are worried reduce exposure to NN50. Do what makes you sleep better but don’t let regret spoil your sleep either.
You also redeem from Nifty and shift to debt. This will also (to some extent) reset the weights of both indices. See: Should I rebalance between Nifty and Nifty Next 50 systematically?
Example 7: You can’t expect perfection. Just be satisfied that you have removed some profits from a well-performing asset class or you have invested more in an underperforming asset class.
Suppose we have invested Rs. 60 in three equity funds and Rs. 40 in fixed income. So our desired asset allocation is 60:40.
Rs. 30 is invested in a Nifty fund; Rs. 15 in a Nifty Next 50 fund and Rs. 15 in an S&P 500 fund. So 50%:25%:25% is the internal equity allocation.
After one year (and no further investments), the equity investment has become Rs. 82.5 and the fixed income Rs. 42.4.
So now the asset allocation is 66% equity and 34% fixed income. We recommend that investors rebalance at least when there is more than a 5% deviation from the desired asset allocation.
So in this case, 6% has to be removed from equity and shifted to fixed income. How to do this?
The total asset is 82.5+42.4 = 124.9. No 60% of this = 74.9.
So the equity allocation must be reduced from 82.5 to 74.9. That is Rs. 7.56 must be removed.
Now, which fund should I sell? Nifty or Nifty Next 50 or the S&P 500?
We recommend looking for the biggest deviation.
Suppose the 82.5 comprises of 60% Nifty, 19% Nifty Next 50 and 21% S&P 500. We can simply remove the Rs. 7.56 from the Nifty fund and shift it to fixed income.
Then the internal allocation will become 56% Nifty, 21% Nifty Next 50 and 23% S&P 500. This is close enough to the 50:25:25 ratio we started with and is good enough.
Of course, one could have also removed Rs. 12 from the Nifty fund. From this amount, Rs. 2.9 can be added to Nifty Next 50 and Rs. 1.4 to the S&P 500 fund and the rest shifted to fixed income. This ensures both 60:40 equity: fixed income allocation and 50:25:25 internal equity allocation but may be overkill and additional tax burden.
It is enough if we focus first on the overall asset allocation and approximate internal weights (unless there is a significant deviation: eg. +35% return in Nifty and -15% return in S&P500/NN50). Also, the fund you choose to redeem from will keep changing from year to year.
Finally, as mentioned above, the overall asset allocation should be gradually varied to ensure the actual corpus is close to the target corpus at any given point in the journey.
Here is a seminar to get started: Basics of portfolio construction: A guide for beginners
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