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How well do your clients understand the benefits of portfolio rebalancing?

22 April 2020 | Portfolio construction

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Many advisers recognise the value of periodic portfolio rebalancing to maintain their clients' target asset mix. After all, asset allocation has been shown to be the most important factor in determining long-term investing success.1

Yet clients often express resistance to the idea of rebalancing their portfolios. One of their most common objections: why sell the winners and buy more of the assets that have less impressive returns? Why not do the precise opposite to reap maximum returns?

To help address those questions, we have pulled together some data that might be useful in explaining the consequences of portfolio drift and the benefits of periodic portfolio rebalancing.

Portfolio drift

Asset allocation will drift gradually during normal market cycles, but this effect can become more acute during times of increased volatility. Given the current market environment, clients may be more receptive to the risk-mitigating benefits of portfolio rebalancing.

The below chart shows the impact of portfolio drift over the long-term.  The initial allocation for both portfolios is 60% global equity and 40% global bonds. The rebalanced portfolio, as illustrated below, is returned to its target allocation at the end of each June and December, whereas the non-rebalanced portfolio drifts to more than 80% equity over time – greatly changing the risk profile of the portfolio.

Changes in stock exposure for a rebalanced portfolio and a 'drifting portfolio',

January 1960–December 2019

Source: Vanguard calculations, based on data from Thomson Reuters Datastream and Bloomberg Barclays.
Notes: The initial allocation for both portfolios is 60% global equity and 40% global bonds. The rebalanced portfolio is returned to this allocation at the end of each June and December. Global equity is defined as the MSCI All Country World Investable Market Index, GBP un-hedged. Global bonds are defined as the Bloomberg Barclays Global Aggregate, hedged to sterling. Returns are in GBP with income reinvested

 

Historically, higher-return assets have brought increased risk

The objective of portfolio rebalancing is to minimise risk rather than maximise return, which can be difficult to extol when markets are rising. In the current environment, the message might be a little easier to convey.

The chart below shows the best, worst and average returns for different stock/bond allocations over more than a century. Higher expected return comes with heightened risk, which over time can be mitigated by regular rebalancing to realign with an individual's risk appetite.

Best, worst, and average returns for various stock/bond allocations, 1901-2019

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: Reflects the maximum and minimum calendar year returns, along with the average annualised return, from 1901-2019, for various stock and bond allocations, rebalanced annually. Equities are represented by the DMS UK Equity Total Return Index from 1901 to 1969; thereafter, equities are represented by the MSCI UK Index.   Bond returns are represented by the DMS UK Bond Total Return Index from 1901 – 1985; the FTSE UK Government Index from Jan 1986 – Dec 2000 and the Bloomberg Barclays Sterling Aggregate Index thereafter. Returns are in sterling, with income reinvested, to 31 December 2019.
Source: Vanguard

 

Over time, different asset classes have produced different returns and, correspondingly, different levels of volatility.

More portfolio return consistency through balance

Annual returns by asset class (%), from the highest to the lowest, 2009–2019

Past performance is not a reliable indicator of future results.
Source: Vanguard calculations, using data from Barclays Capital and Thompson Reuters Datastream.  Global equity  is defined as the FTSE All World Index,  North America equity as the FTSE World North America Index, Emerging market equity as the FTSE Emerging Index,  Developed Asia equity as the FTSE All World Developed Asia Pacific Index,  European ex-UK equity as the FTSE All World Europe ex-UK Index, UK equity as the FTSE All Share Index, UK government bonds as Bloomberg Barclays Sterling Gilt Index, UK index-linked gilts as Bloomberg Barclays Global Inflation-Linked UK Index,  UK investment grade corporate bonds as Bloomberg Barclays Sterling Corporate Index, Hedged global bonds as Bloomberg Barclays Global Aggregate Index (hedged in GBP), 60 equity, 40% bonds portfolio represented by LifeStrategy 60% Equity Fund performance.  Returns are denominated in GBP and include reinvested dividends and interest. Performance shown is cumulative and includes the reinvestment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV. Please be advised that the performance of the LifeStrategy 60% Equity Fund from 1/1/2008 to 23/06/2011 is simulated. Simulated performance figures do not represent actual fund activity, and may not take account of relevant economic and market factors impacting actual fund performance. Simulated and actual past performance is not a reliable indicator of future results.

 

Advisers have a range of options with which to approach rebalancing:

Time only—rebalancing on a set schedule, such as daily, monthly, quarterly or annually.

Threshold only—rebalancing when a target asset allocation deviates by a predetermined percentage, such as 1%, 5% or 10%.

Time and threshold—rebalancing on a set schedule, but only if a target asset allocation deviates by a predetermined amount, such as 1%, 5% or 10%.

Many advisers use rebalancing software to eliminate any uncertainty over which option might yield the best outcome. Otherwise, the chosen approach can simply hinge upon your practice's preference.

Gaining buy-in from clients for strategies such as rebalancing can be as simple as providing them with a "why" that answers their questions or satisfies their objections. For instance, they may want to know more about your firm's rebalancing methodology—what is the process, how often does it happen, does it usually result in significant capital gains taxes or transaction costs and how significant a risk reduction can they expect in return?

Rebalancing can also be combined with and complement other strategies, such as tax-loss harvesting. Vanguard research shows that advisers can add appreciable value over time, through activities such as rebalancing and behavioural coaching in general2.

In addition, Vanguard research has determined that none of the major rebalancing approaches holds a distinct or enduring advantage over the others. Therefore, the most important consideration is for advisers to apply rebalancing to client portfolios in a consistent and disciplined manner to give clients the best chance of reaching their long-term financial goals.

 

Rebalancing: The diversification defence

Share this piece with clients to show how rebalancing a diversified portfolio can help dampen volatility while still delivering a level of return that can help clients meet their long-term financial goals.

Download client guide

How rebalancing reduces your clients' risk

Share this piece with your clients to help them understand how a well-planned rebalancing strategy can be used to help dial down risk in their portfolios.

Download client guide

 

1 Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, 1995. "Determinants of portfolio performance." Financial Analysts Journal 51(1):133–8. (Feature Articles, 1985–1994.)
2 Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, Yan Zilbering, and Donald G. Bennyhoff, 2019. Putting a value on your value: Quantifying Vanguard Advisor's Alpha®. Valley Forge, Pa.: The Vanguard Group.

 

 

This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. This document is designed for use by, and is directed only at, persons resident in the UK.

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Simulated and past performance are not reliable indicators of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

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