Strategies For Rebalancing Portfolio

Two of the most pertinent questions facing long term equity investors are, one, whether to adopt a ‘buy and hold’ strategy; or two, whether one should ‘keep rebalancing the portfolio’ continuously. Majority of the investors who have created wealth in equity markets would agree the answer lies somewhere between.

While it has been a rewarding experience for several investors who bought equities over the past decade and have been holding on to the same, we find that there are very many portfolios which were constructed in 2007 and are on hold mode even today even after underperforming heavily.

Vijay Kapare, an equity investor, says “I have been lucky in the market as I bought Bajaj Finance, Bajaj Finserv and Indusind Bank in my portfolio almost 10 years back and I am still holding these stocks. I am making almost 6917.5 per cent, 885.6 per cent and 2701.6 per cent returns, respectively, in these stocks so far. Such extraordinary returns would not have been possible if I would not have adopted ‘buy and hold’ strategy”. The case of Vijay Kapare is one of the best examples that include top three performers in the past 10 years. But the question is - How many people would be as lucky as Vijay to identify and hold multi-baggers in the portfolio? Most importantly, how many will have the patience to hold on to the stocks for more than 10 years when the stocks are showing an uptrend. In theory, a simple ‘buy and hold’ strategy sounds promising. However, in reality, this strategy requires immense patience and the right temperament (often lacked by many). The buy and hold strategy also has an opportunity cost attached to it.

For example, let us say an investor picked up Tata Global Beverages in 2010. This stock traded in the range of Rs95 to Rs100 during January 2010. Over the next five years, the stock traded in the price range of Rs100 to Rs160 and managed to trade at around Rs120 in January 2017. During the same period, any investor who believed in the buy and hold strategy would have seen his or her capital blocked in Tata Global Beverages for good five years during which period the returns were flat, while the Sensex itself delivered close to 50 per cent returns during the period. Hence, in spite of picking up a quality stock, the investor had to face flattish returns for almost five years. If we consider the data from January 2010 till January 2011, we find that by investing in Tata Global Beverages any investor who adopted a ‘buy & hold’ strategy would have not only locked up his capital in the stock, but would have also missed the opportunity of investing in any of the 230 stocks that had managed to deliver returns in excess of 15 per cent during this period. Therefore, the opportunity cost is high in the ‘buy and hold’ strategy 

The problem with the buy and hold strategy is that the strategy to yield results consumes a lot of time running into several years and a majority of the long-term investors are not willing to wait for so long. An active investor who believes in rebalancing the portfolio, on other hand, can replace the underperforming stock or at least reduce the weightage of the underperforming stock, thus creating a possibility for the portfolio to perform better. 

While portfolio rebalancing may be desirable, it must be remembered that rebalancing portfolio is not an easy exercise. Any rebalancing strategy should accommodate changes in the financial market environment and in asset class characteristics. Rebalancing strategy should also account for an individual investor’s unique risk tolerance and time horizon. 

Pros and cons of ‘buy and hold’ strategy:- 

What is portfolio rebalancing? 

Rebalancing of portfolio is done by realigning the weightages of the assets in the portfolio and involves periodically buying or selling assets to maintain the original portfolio asset allocation plan. 

Advantages of rebalancing portfolio 
 Balancing risk and reward
 Portfolio rebalancing enforces discipline
 Helps investor stay on track with his financial plan 

Various portfolio rebalancing strategies :- 

In order to minimise risk and retain the original portfolio allocation strategy, a long term investor can rebalance portfolio by adopting any of the following three portfolio rebalancing strategies:- 

1. Time only strategy: 

In this portfolio rebalancing strategy, the portfolio is rebalanced at the predetermined time intervals only. For example, the time interval could be daily, monthly, quarterly, semi-annually, annually, etc. 

2. Threshold or trigger-based rebalancing strategy: 

This strategy can be adopted when the portfolio deviates from its target asset allocation by a pre-defined minimum percentage, e.g. 5 per cent, 10 per cent, 15 per cent or 20 per cent. Here, the level of portfolio monitoring would be high, and the portfolio may be required to be monitored almost on a daily basis. 

3. Combination of time and threshold-based rebalancing strategy:- 

As the name suggests, this strategy is a mix of both ‘time only’ and ‘threshold only’ strategy. Here, an investor has to monitor the portfolio at predefined regular intervals. However, the rebalancing should be done only when the portfolio allocation deviates from the original portfolio allocation by a predetermined minimum rebalancing threshold 

When you don’t need rebalancing:
 If all your investments are held in a fund that automatically does the rebalancing for you
 If you have a portfolio advisor who manages your investments for you. 

Example:- Time only rebalancing strategy 

In the table below, it is assumed that an investor is creating an aggressive portfolio which has 80 per cent allocation made for high beta stocks and 20 per cent for low beta stocks. Such a portfolio of high beta stocks is created as the investor believes the market is expected to do well in the future. 

The important thing to note here is that a high beta stock means a stock that has a tendency to provide better returns than the Sensex, while a low beta stock is a stock that has a tendency to provide lower returns than the key benchmark index when the market is in an uptrend.

Investors can rebalance the portfolio after three months by either selling the high beta stock and or buying the low beta stock as the objective is to maintain the target portfolio allocation of being invested in 80:20 ratio for high beta stocks vs low beta stocks. The investor can then decide whether the rebalancing needs to be done after 3 months, 6 months, 9 months or 12 months. 

In all the three tables above, we find that with the movement in the markets, the original portfolio allocation changes as time progresses. Under time only rebalancing strategy, the investor will attempt to modify the portfolio only after the predetermined time interval, viz., 3 months, 6 months or 12 months. The portfolio is then rearranged to maintain the target portfolio allocations. 

Example : Threshold or trigger-based portfolio rebalancing 

In the example below a portfolio is constructed for bullish market environment with a target asset allocation as 30 percent in Large Caps, 60 per cent in Mid-caps and 10 per cent in small-caps. The example highlights how with the change in stock prices the original asset allocation shifts to the fresh asset allocation 

Shantanu Awasthi
Karvy Private Wealth 

Why should one rebalance the equity portfolio and how frequently should the rebalancing be done? 

Capital markets are very dynamic and the economic scenario also keeps changing and this is the reason for revisiting one’s portfolio and rebalancing it, if required. Usually, one should make a strategic allocation with a long term perspective of 5 to 10 years. The strategic allocation is based on combination of factors, such as personal demographics like age, occupation and financial goals, etc. along with the risk-taking ability of an individual. However, since the markets are dynamic, one could revisit the portfolio on a quarterly or semi-annual basis, but it is recommended that rebalancing or tactical allocation should be done on an annual basis, unless there is some major event that affects the overall markets or economic scenario. This helps, as too frequent changes involve transaction costs, taxes and trends emerge only over a period of time. 

Does rebalancing always work? 

Rebalancing is a very effective tool in the long run and helps generate substantial alpha over a period of time. However, the frequent rebalancing can become counterproductive and might result in underperformance because of cost and not enough time being given for a stock to perform. It is important that before allocating funds, proper planning and strategy is worked out and, in the long run, stick to the same strategy. Rebalancing then should be done only on the basis of any changes in the fundamental parameters based on which the strategy was devised. Most of the portfolio managers who have been outperforming in the long run have always followed this rule 

In the example below a portfolio is constructed for bearish market environment with a target asset allocation as 70 percent in Large Caps, 25 percent in Mid-caps and 5 per cent in Small-caps. 

In this rebalancing strategy, the rebalancing event will happen only when the asset values shift by the predefined limit, i.e. 10 per cent. In other words, investors should rebalance the portfolio whenever the large-caps, mid-caps or small-caps drift 10 per cent on either side, if the threshold limit is set at 10 per cent. As seen in the above tables, an investor can keep a higher threshold limit in order to minimise the transaction costs and avoid overtrading in the portfolio. 

The third strategy that is more appealing to investors, i.e, a mix 

Nitasha Shankar
Senior Vice President and Head of Research, YES SECURITIES (I) Limited 

Why should one rebalance the equity portfolio and how frequently should the rebalancing be done? How frequently should a long-term investor rebalance equity portfolio? 

A long-term investor would buy a stock with a particular investment thesis in mind. It could be factors like favourable valuations (due to stock/sector being not in flavour), or high growth or margin expansion, which may lead to above average profit growth during a particular period. As such, it would make sense to let two to four quarters to pass by to gauge whether one’s investment thesis is playing out or not. 

Under what circumstances is re-balancing of portfolio a must? 

Stock rebalancing is a must when the fundamental thesis is proven wrong. For instance, if the company goes through an unrelated acquisition, undertakes a venture that leads to capital destruction, etc. It is also prudent to rebalance the portfolio when it becomes highly skewed towards any particular stock or sector due to better-than-expected performance of the underlying stock. of “time only” and “threshold or trigger based” strategy, will allow investors to review portfolio at predefined time intervals (3 months, 6 months, 12 months, etc.). However, the portfolio rebalancing can only be executed when the set threshold limits are triggered. For example, if an investor has decided to do a semi-annual review of the portfolio and has set a threshold limit of 10 per cent for portfolio rebalancing, he or she should

study the portfolio performance every 6 months and rebalance the same only if the portfolio value has moved by 10 per cent in either direction. 

Costs of rebalancing 

Pursued with the aim of mitigating opportunity cost, portfolio rebalancing may also be accompanied by some unavoidable cost. The costs attached to rebalancing may come in the form of additional taxes, time and efforts. 

In the case of rebalancing within taxable registrations, the assets that have been sold at an appreciated value are subject to capital gains taxation. Supplementing the taxation cost, rebalancing also involves transaction costs that manifest in the form of commissions and fees. Individual securities and exchange traded funds are accompanied by brokerage commissions and bid-ask spreads (difference between the highest price offered by a buyer and the lowest price accepted by a seller), while mutual funds are accompanied by purchase or redemption costs. 

Guinness Securities 

❝ Portfolio rebalancing is the process of realignment of weightage of assets in a portfolio. In the case of market oscillations, portfolio rebalancing safeguards the investors by reducing Rama Ratnam Senior Investment Professional ❝ The most effective rebalancing methodology in my experience has been a trigger-based approach as compared to a frequency-based approach, as technically you might miss out on the momentum of an investment idea in the latter. A disciplined approach to rebalancing portfolios gives a better risk-adjusted return, i.e., it creates additional return and lower volatility as compared to a portfolio which is seldom or never rebalanced. The context of rebalancing and active portfolio management becomes more effective in emerging markets as compared to developed markets, as good stock selection at right values empirically generates better alpha in emerging market economies because of a higher information asymmetry in these markets, and the concept of value growth becomes more significant.❞ the additional risk that stems from a drift in asset weights and maintains a risk-return trade off. The optimum rebalancing strategy depends on the unique preferences of the investor as it takes into consideration an investor’s risk tolerance, time horizon and financial goals. ❞ 

Abhishake Mathur
Sr. VP – ICICI Securities. 

❝Rebalancing is must if there is a change in risk profile or asset allocation❞

How frequently should a long term investor rebalance his portfolio? 

Rebalancing should happen if there is a deviation in the asset allocation from the target allocation. The trigger to rebalance can be based on a set frequency. 

It is advisable to check for any deviations and rebalance at least once a year. A better way is to set a corridor limit (of say, plus-minus 5%) and rebalance once the deviation crosses these limits. 

Why is rebalancing required in a portfolio? 

A portfolio comprises various asset classes. This may include equity, debt, gold, etc. A healthy portfolio should have a mix of all assets in a proportion that meets your financial objectives. For example a growth-oriented portfolio should have much more exposure to equity. Now, an adverse movement in equity reduces the proportion of the portfolio in equities as compared to the target. This is a trigger for an investor to rebalance and sell other assets to buy more of equity. 

Similarly, if equity performs well, it changes the allocations, triggering a 'sell' in equity and a 'buy' in other assets. Essentially, a target allocation strategy helps to buy at lows and book profits at highs, in a disciplined manner. 

Under what circumstances is rebalancing of portfolio a must? 

A change in risk profile or a large difference in asset allocation with respect to the target are important circumstances where one should rebalance.

The cherry-picking of the most promising stocks for the refurbishment of portfolio consumes humongous amount of time, research and labour. This burden is placed on the investor or the professional investment manager.

While rebalancing may be a prerequisite to beat the markets, to sustain the original target returns and bring the portfolio out of stagnancy, a pragmatic and less-frequent approach towards rebalancing is more preferable and promising 

A portfolio must be rebalanced to maintain it original risk and return characteristics over time 

A‘buy and hold’ strategy without rebalancing the portfolio in these stocks would have had heavy impact on total portfolio returns. 

Conclusion: - 

Just like there is no single universally acceptable strategy to beat the markets, there is no single universally acceptable portfolio rebalancing strategy that can be useful for investors in generating extra returns. However, a clear advantage of adopting a predefined rebalancing strategy is that it helps to closely align the portfolio’s risk-return characteristics with the risk-return characteristics of the target portfolio. While rebalancing portfolio is not easy and has a cost element attached to it, we recommend investors to look at rebalancing portfolios on an annual basis at least, if not on semi-annual basis. 

Also, the threshold or trigger limit can be placed at 15 to 20 per cent for rebalancing the portfolio. By keeping a threshold of 15 to 20 per cent and by rebalancing on semi-annual or annual basis, the cost of rebalancing can be optimised. Regular portfolio rebalancing is one of the most important elements of overall portfolio management and it can help reduce the downside investment risk. Also, portfolio rebalancing is a must as it will ensure that investments are allocated in line with the investor’s financial plan. Rebalancing will provide investors an opportunity to sell high and buy low as the strategy facilitates taking gains from high-performing investments and reinvesting them in areas that have underperformed. Systematic rebalancing will also help remove the emotions out of the investing process, which can prove to be extremely beneficial in the long run.