Reducing costs due to allocation drifts

The Nifty Index has declined 24 per cent since this January. This fall, however, conceals the short-term volatility in the index. Between August and October 2011, the Nifty Index rose 14 per cent only to give back all the gains in November.

Such volatility questions the relevance of buy-and-hold investment. Market timing could, perhaps, improve portfolio returns during such volatile conditions. Since individuals cannot easily time the market, the question is: Is it optimal for investors to have a rebalancing strategy to systematically capture returns and reduce unintended risks?

This article discusses the need for a rebalancing strategy and shows how such a strategy reduces unintended risks. It then explains the types of rebalancing strategy and the relevance of such strategy within the core-satellite framework.

Allocation drifts

Consider an investment portfolio that has a strategic asset allocation of 60/40 between stocks and bonds. Suppose increase in equity prices changes the allocation to 75/25. Without rebalancing, a subsequent fall of 20 per cent in equity would cost the portfolio 3 per cent due to the allocation drift; 15 percentage points (75 per cent minus 60 per cent) of allocation drift times 20 per cent decline in equity.

That is not all. Consider a situation when exposure falls to 45/55 due to decline in the equity market. If the portfolio is not rebalanced, the lower equity exposure would lead to high opportunity cost if equity values subsequently move up.

In either case, the portfolio is subject to unintended risks because the stock-bond exposure is different from the strategic asset allocation. It is, hence, optimal to continually rebalance the portfolio.

A portfolio that has no well-designed rebalancing policy actually has a random policy.

A random rebalancing policy can lead to higher risk. Why? All investors succumb to greed and fear. Buy-and-hold investors are no exception. Without a well laid-out rebalancing strategy, such investors would be driven by greed to buy late into an uptrending market, or driven by fear to sell late into a downtrending market.

A rebalancing strategy, on the other hand, provides a game-plan to act during such market conditions. The question is: How should investors frame such a strategy?

A typical allocation policy could state 55/45 stocks and bonds with a tactical range of 5 percentage points. This essentially means that the portfolio can carry equity exposure between 50 per cent and 60 per cent. The rebalancing policy could be based on a calendar or could be contingent on the strategic allocation policy.

A calendar rebalancing policy could simply state that the portfolio has to be rebalanced, say, every half year. A contingent policy requires rebalancing the portfolio only if the equity allocation declines below 50 per cent or rises above 60 per cent in above example.

A rebalancing policy is essentially a trade-off; it ought to ensure that the portfolio does not suffer high costs due to allocation drifts and yet minimises costs from frequent rebalancing. Empirical evidence suggests that allocation drifts with 10 per cent rebalance band and 5 per cent tolerance band is optimal.

Suppose the strategic asset allocation is 55/45 between stocks and bonds. The portfolio ought to be rebalanced if equity, for instance, declines below 49.5 per cent or rises above 60.5 per cent (10 per cent of 55 per cent).

The tolerance band of 5 per cent means that equity exposure can be rebalanced to either 52.25 per cent or 57.75 per cent (5 per cent of 55 per cent) and not necessary brought to the strategic allocation of 55 per cent.

Conclusion

A rebalancing policy typically covers the entire portfolio. But it would suffice if investors design a rebalancing strategy for their core portfolio.

The reason is simple. The core portfolio contains passive exposure to equity and, is hence, subject to the risks associated with buy-and-hold investment, if not rebalanced continually.

The satellite portfolio, on the other hand, is set-up to engage in market timing and tactical asset allocation and is, hence, implicitly rebalanced regularly.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor learning solutions. He can be reached at > enhancek@gmail.com)