The investment strategy of every portfolio has to be reviewed regularly to ensure that performance, market forces and cash inflows and outflows are not throwing the asset balance out of kilter. The critical issue is how often rebalancing should be done, and what should trigger it?
The investment strategy of a retirement fund, an individual or a major life assurance company is not something that is drawn up once and then forgotten. Cash flowing in or out of the fund and investment growth or losses mean that constant adjustments have to be made to the composition, or balance, of the assets to ensure they are brought back into line with the original investment strategy.
According to an article in the Investment Analysts Journal by Colin Firer, J. Peagram and W. Brunyee - three academics from the University of Cape Town's Graduate School of Business - market movements will, over time, cause the amounts (weightings) invested in the various asset classes to move away from the benchmarks established in an investment strategy. This means a portfolio manager has to actively intervene to rebalance the portfolio and bring the weightings back into line with the investment strategy.
Rebalancing, the three academics say, is the process of adjusting an investment portfolio to meet the desired asset allocation mix.
The difficult question is deciding when this rebalancing should be done. Should it be done at the asset manager's discretion in an attempt to achieve the maximum returns? Or on a particular date? Or as a result of a "trigger event" (for example, when the weighting of a particular asset moves above a pre-determined percentage)? Or perhaps portfolio managers should simply allow the portfolio to drift?
The correct answers to these questions are as important to the managers of large portfolios as they are to individual investors, particularly those who are trying to manage investment risk efficiently.
Firer, Peagram and Brunyee looked at 11 asset allocation structures and applied four different rebalancing strategies to each of the 11 portfolios.
Three of the strategies were time-based - the portfolios were rebalanced monthly, quarterly and annually. The fourth strategy was trigger-based - the portfolios were rebalanced when the assets deviated by more than five percent, either up or down, from the investment strategy. In addition, the academics also tested a "drift" strategy with no rebalancing.
What did they find?
"Drifting" provided the best returns for all 11 portfolios, but at the cost of greater volatility and therefore risk. Of the four rebalancing strategies, "trigger" rebalancing provided the best returns over all 11 portfolios, sometimes with greater volatility and sometimes with less volatility, than the three time-based strategies.
The time-based strategies produced a variety of results, which often depended on whether or not the portfolio contained foreign assets. Overall, the one-month strategy reduced volatility risk more efficiently than the quarterly or annual strategies.
The study shows that investment managers need to carefully consider how they rebalance portfolios, because the strategies they employ produce different results, which, over the long term, will affect investment returns.
How they do it
The question arises, what rebalancing strategies do South Africa's major asset managers follow, not only with retirement funds, but all types of asset allocation investments, where they can alter the composition of the portfolio's asset classes.
A survey by Personal Finance shows a mixed approach. In alphabetical order:
- Abvest.
Wynand van Niekerk, who is responsible for asset management, says trigger rebalancing is used if the benchmarks conform to the prudential investment guidelines (PIGs), which, among other things, restrict a portfolio to investing 75 percent of its assets in equities. If the equity component deviates by more than 2.6 percent - either up or down- from Abvest's targeted weighting, the portfolio is rebalanced to half of the drift.
However, Van Niekerk says, Abvest will also rebalance if a portfolio is going to fall out of line with the PIGs; if there is a change of Abvest's view on the optimal weightings of the different asset classes; and in terms of any client mandate.
- African Harvest Fund Managers.
Rowan Williams-Short, the chief executive, says African Harvest rebalances "in a dynamic or an event-driven fashion". It does not rebalance in calendar periods, because "markets do not conveniently produce opportunities in line with investor calendars".
African Harvest is influenced by factors such as changes in the value it places on different asset classes and cash inflows or outflows, with the cash flows managed so that asset allocations remain consistently in the same proportions.
- Investec Asset Management (IAM).
Clyde Rossouw, a portfolio manager, refers to two unit trust portfolios to illustrate IAM's approach to rebalancing.
In the case of Investec's Opportunity Fund, which is effectively a value-style asset allocation fund, the asset manager attempts "to identify those assets that will generate the best return at lower risk. We have strict targets for where we think these instruments should be trading, and once these targets are reached, we either switch or sell out of them," Rossouw says.
In the case of Investec's Managed Fund, an asset allocation fund that is managed in terms of the PIGs, Rossouw says changes are made in line with IAM's view of the macro-economic outlook. This is unless the fund exceeds the PIGs, when rebalancing is immediate.
- - Metropolitan Asset Managers.
Ian Troost, a portfolio manager, says Metropolitan rebalances its portfolios once a month. However, views are taken regularly on the proportions a portfolio should have in a particular asset class. Rebalancing is also sparked by the need to comply with the PIGs.
- Old Mutual Asset Management (OMAM).
Charles de Kock, the head of asset allocation and strategy, says OMAM does not treat PIG funds and flexible funds differently.
"We actively manage portfolios from an asset allocation perspective, taking positions away from each portfolio's long-term asset allocation benchmark in accordance with our model portfolio (house') views," De Kock says. The "house" views are based on OMAM's analysis of the medium-term prospects of the various asset classes.
"The size of the position taken is carefully controlled from a risk perspective, and differs according to the risk constraints of the particular fund," De Kock says. "As such, we don't seek to specifically rebalance to a benchmark, since our active positions are typically different from the benchmark.
"Sometimes our views remain unchanged for a long period of time, and a portfolio moves out of sync with this view due to market movements. At this point, we weigh up the cost of re-balancing versus the risk inherent in the position, and re-align the portfolio as soon as we believe benefits outweigh costs," he says.
"The two most common events sparking a re-alignment of the portfolio are a significant change in our view, or significant market moves in asset classes. Market moves which take a portfolio allocation outside any regulatory constraints (such as the PIGs) would be corrected immediately."
- Sanlam Investment Managers
normally rebalances its portfolios at month-end or when pre-set limits are exceeded. Rebalancing can also be triggered by Sanlam's outlook on the markets.
- Stanlib Asset Management.
John Koel, the chief investment officer, says where Stanlib has full discretion, asset allocation targets are reviewed monthly, taking into account market movements, with new targets set on the basis of the expected risk-adjusted returns from the major asset classes over 12 months.
In cases where clients set explicit benchmarks, a drift outside the mandate will trigger rebalancing. Koel says rebalancing is done either quarterly or monthly; or intra-monthly if there have been extreme market movements; or when new asset allocation targets are set; or if the PIGs are breached; or if client mandates are exceeded.
HOW TO KEEP YOUR BALANCE
As is the case with the managers of large, institutional portfolios, individuals should have an investment strategy. Your strategy should be based on your risk profile and financial requirements.
Once you - or you and your financial adviser - have settled on a strategy and have decided how much to invest in each of the main asset classes, you will also need a rebalancing strategy.
Rebalancing is an essential part of managing an investment portfolio. Among other things, it ensures you maintain a properly diversified portfolio, which, in turn, reduces your investment risk.
For example, say in 1996 you invested in unit trust funds that specialised in technology stocks. At the time, your investment in technology funds amounted to five percent of your overall portfolio. A year later, as the technology boom got under way, this investment would have grown rapidly in relation to your other investments, so that it amounted to 15 percent of your portfolio. You would have been feeling pretty chuffed. But in 2001, the bottom fell out of the technology sector, and your investment would have shrunk to only two percent of your portfolio.
The key, when you get abnormal growth, is to stick to your original investment strategy by selling a portion of the out-performing assets, thereby maintaining the original diversification of your portfolio.
If we applied this rebalancing strategy to the example above, you would have reduced the 15 percent proportion in technology funds to five percent. This would have enabled you to take profits from the growing investment and, simultaneously, would have reduced the risk to your overall portfolio when the bubble burst.
On the other hand, let us imagine the growth in technology stocks had continued. Reducing your investment in the technology sector to five percent would not have harmed your cause, because you would have continued to pick up the growth on that portion.
However, as Wynand van Niekerk, who is responsible for asset allocation at Abvest, points out, the cost of changing investments can be high for individuals, and the benefits of rebalancing must outweigh these costs.
Charles de Kock, the head of asset allocation and strategy at Old Mutual Asset Management, says new contributions (for example, a lump-sum investment) could be used to bring your portfolio closer in line with your personal long-term asset allocation, but "we would not advocate that the average individual investor disinvest funds to rebalance".
The costs of rebalancing can vary, depending on the type of investments you have. Many investment vehicles in which you are allowed to choose the underlying investments are structured to permit switching between different types of assets and divisions of asset classes. In most cases, the switches cost 0.25 percent of the value of the amount being switched.
However, if you are switching outside of these products, the disinvestment and reinvestment charges could be exceptionally high.
Clyde Rossouw, a portfolio manager at Investec Asset Management, says that, generally, you should choose investment products where the portfolio manager makes the asset allocation decisions. But if you insist on using specialist unit trust funds, he says, there may be a need to rebalance, because both market conditions and your perceptions of the markets may change.
John Koel, the chief investment officer at Stanlib Asset Management, agrees, saying the individual investor should consider balanced (asset allocation) unit trust funds, where investment professionals are making the asset allocation calls.
If you want to develop your own investment strategy, he says, you should do so with the help of an investment adviser who understands risk and return. Then you should select an appropriate asset mix that suits your long-term objectives, decide on a target percentage for each asset class, and set upper and lower limits for each asset class.
For example, if your target for equities is 50 percent, you should have a minimum and maximum range of 7.5 percent around that target. In other words, if the proportion of equities moves down to 42.5 percent or up to 57.5 percent, you should rebalance to bring equities back to 50 percent.
Ian Troost, a portfolio manager at Metropolitan Asset Management, warns that investors "should not rebalance in an attempt to time markets. Most individual investors tend to buy at the top and sell at the bottom. They tend to increase their equity weighting when the market has already run 30 percent".
He recommends rebalancing to a long-term strategic benchmark once every quarter.
Cash flows can also affect the asset balance in your portfolio, and cash flows need to be managed to stay in line with your investment strategy.
Rowan Williams-Short, the chief executive of African Harvest, says it is common for individuals to make the mistake of hanging on to money they could invest, "possibly in the hope of buying into market weaknesses". He says this is inconsistent. If you are satisfied with your investment strategy, you should invest the new money proportionally in accordance with your strategy.
This article was first published in Personal Finance magazine, 2nd Quarter 2004. See what's in our latest issue