It’s a question that divides advisers: Is rebalancing important? Can it make much of a difference? And how often should it be done?
The answers being (after careful research): yes absolutely; yes it really can; and it depends but probably daily.
Rebalancing needn’t be good hygiene or just used to keep the portfolio generally on the right track. The reality is that different rebalancing regimes can make a big difference to returns, particularly when market volatility is in play. More on this later.
To determine the worth of rebalancing we looked at multi-asset risk targeted solutions (very much a growth market), and researched which rebalancing method would have delivered the greatest benefit over the last 10 years: daily, monthly, quarterly or, no rebalancing at all. We chose multi-asset funds as they vary widely in their approach to rebalancing, but still need to stick as closely as possible to an asset allocation model. Hence we believe rebalancing is most important when dealing with risk targeted funds.
Before we look at the results it’s useful to have a quick refresher on risk targeted solutions. These are designed to be managed within a specific risk band and are often monitored by a third party, who quantify the different risk and return profiles of different asset classes, blending them to come up with a range of asset allocation models, typically from 1 (low risk) to 10 (high risk). Risk targeted model portfolio solutions are then matched to these asset allocations, often matching to profiles 3 to 7.
Risk targeted funds are designed to stay within their set risk profile. Of course the natural inclinations of the underlying assets will skew allocations over time, changing the risk profile and leaving the fund unsuitable for some investors. Hence their performance is a great way to investigate the value of rebalancing.
How did the funds perform?
You can see how the funds performed over the last 10 years in the chart below.*
|Rebalancing technique||Portfolio 3||Portfolio 4||Portfolio 5||Portfolio 6||Portfolio 7|
Source: Morningstar & Canada Life Investments research. Data from 28 February 2007 to 28 February 2017.
A Portfolio 7 fund that was rebalanced daily would have returned over 10% more than one that was never rebalanced, while the Portfolio 3 fund was nearly 4% ahead of a monthly rebalanced portfolio.
The findings show that in general the biggest gains are made when the rebalancing happens daily.
Interestingly, the biggest performance difference is found with the more volatile funds. This feels intuitively right: being the most prone to change they have the greatest opportunity to wander out of their allocation and get in to unsuitable territory. So they also provide the greatest opportunity, after daily rebalancing, to keep them on track with suitability.
The value of daily rebalancing is further highlighted by another huge growth area, passive investing. The performance of difference passive products – tracking the same index – often varies wildly. Much of this can be attributed to each individual products’ tracking error. Funds with a high tracking error tend to underperform, whilst funds that boast a low tracking error tend to track their benchmark very closely. Often, the best performing trackers are those that rebalance the most frequently, tracking the benchmark most effectively.
Ultimately, the findings are something of a retort for those who, after citing cost and convenience, have long suggested that it’s not worth rebalancing these kinds of portfolios every day. From our analysis, it’s not just worth doing, it’s worth doing daily to get the biggest benefit.
*We used a typical asset allocation model for risk target funds, using data constructed from third party agencies responsible for monitoring these kinds of products. Using different indices for each asset, we collated daily price information for each in order to analyse performance over the last 10 years.