Portfolio rebalancing is one of those topics that you hear a fair bit about, but it is quite often overlooked. That is unfortunate, because by following a disciplined rebalancing program, it is quite likely that you can increase
your total return, while actually reducing
your overall risk. Here’s how it works.
How does this happen? The simple explanation is that by following a portfolio rebalancing program, you are forcing yourself to sell high and buy low. Essentially, you take profits in those investments that have experienced significant gains and are potentially overvalued, while adding to those that are currently out of favour with other investors. This regular profit-taking reduces the amount invested in the overvalued investments, helping to reduce your downside when the selloff eventually occurs.
As an example, I set up a simulated portfolio with the same asset mix as the Couch Potato Portfolio we track in my Mutual Funds/ETFs Update
newsletter: 40% FTSE TMX Canada Universe Bond Index; 30% S&P/TSX Composite Index; 15% S&P 500; and 15% MSCI EAFE Index. If I look at the returns for the 10 years ending December 31, a $10,000 investment would be worth $18,109, for an annualized gain of 5.07%. This return assumes that there was no rebalancing and that all distributions were reinvested.
These returns can be improved by following a simple rebalancing program. I looked at monthly, quarterly, semi-annual, and annual rebalancing. As shown in Table 1, in every case, the return was increased and the volatility, as measured by the standard deviation, was lowered.
Next, instead of rebalancing the portfolio based on the calendar, I thought it might be interesting to use asset-mix ranges as the trigger for a rebalance. Using this methodology, a rebalance would take place when the portfolio weight of an investment was outside of a predetermined range, either to the upside or downside. For example, if I used a 10% range, a rebalance would occur when the weighting of the asset class was plus or minus 10% of the target weight. Looking at the bond allocation, a rebalance would happen if the portfolio weight was higher than 44% or less than 36%. I considered three ranges: 10%, 20% and 30%.
Again, in every case, the portfolio returns were higher and the risk was lower than they were if no rebalancing had taken place. In fact, if you let the portfolio weights move as much as 30% away from the target allocation, the returns were substantially higher than if no rebalancing had taken place.
Intuitively this makes sense. By allowing a large enough range, the winners are allowed to run, producing higher gains for the portfolio. Once the range threshold is broken, the portfolio is rebalanced, with profits redeployed into the out-of-favour asset classes. The net result is a significantly higher return, both on an absolute and risk-adjusted basis.
Rebalancing in a registered account, such as an RRSP or a RRIF is fairly easy, since there are no tax considerations to worry about. In a non-registered account however, things can get a touch more complicated, because a rebalance may result in a realized capital gain.
In a non-registered account, one of the best ways to rebalance is through the addition of new money into the account. When you make a new investment, put the new money in the investments that are below their target weight. If you cannot rebalance with new funds, you will need to weigh the increased risk in your portfolio with the potential tax hit you may realize. If the tax burden is too high, a rebalance may not be worth it to you.
Portfolio rebalancing can be a great way to increase returns and lower portfolio risk. In a registered account, it is a simple and easy process, but the potential tax hit must be considered before rebalancing in a non-registered account.
Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.
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