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Rebalancing act

I have been told that I need to periodically rebalance my portfolio. Please explain this and indicate how frequently I should carry it out.

When you set up your portfolio, you will have gone through an exercise to determine the most appropriate mixture of asset classes correspondingto your risk profile and investment term. This will have resulted in a split between growth investments, typically shares in UK and overseas companies, and fixed-interest investments.

Over time, the asset classes into which you divided your portfolio will have achieved different levels of return. They probably no longer conform to the split which you established at outset. To correct this, it is necessary to reset the asset allocations to their original settings, known as rebalancing.

Two main academic theories affect rebalancing. Mean reversion refers to the concept whereby assets generally return to their long-term average value. The implication is that assets which have reduced in value below their long-term trend should eventually return to it. This phenomenon has been seen to operate over roughly a three-year cycle.

The other factor is momentum. This describes the observed phenomenon whereby asset values tend to continue moving in the same direction for a period. It has often been compared with the movement of a wave which continues to sweep up the beach once it has broken before retreating. Momentum has been seen to occur over shorter periods of typically up to a year.

Mean reversion is a factor which favours more frequent rebalancing since it supports the disposal of assets which have performed well in favour of others which have underperformed.

Momentum supports leaving the portfolio as it is, at least for a while, because it explains how assets which have been performing well can be expected to continue to do so for a period.

Two additional factors influence the frequency of rebalancing – transaction costs and taxation. The latter can be disregarded if the investment is held in tax-exempt shelters such as pensions and Isas. The former is relevant because dealing costs can erode the benefits derived from rebalancing and are a major factor in favour of less frequent rebalancing.

Rebalancing may be carried out whenever the asset allocations stray beyond a certain percentage of target levels or at set intervals – quarterly, half-yearly or yearly – or a combination of the above. The optimum method will depend on the nature of the portfolio.

There is also the question of exactly how to perform the rebalancing exercise, that is, whether to restore all asset allocations to their original levels or for the worst-performing asset classes to be restored to a lower level and the best performing assets to a higher level.

There is a lot of research into the benefits of rebalancing. Some surveys suggest that it can actually increase long-term returns without increasing the risk of the portfolio. However, other research indicates that care needs to be taken over the extent to which this is relied on if the data is based on too short a period. Conclusions drawn from research based on data over, say, the last 10 years may give rise to conclusions about the optimum methods of rebalancing which are not borne out over longer periods.

At an intuitive level, it is evident that the restoration of your portfolio to the original levels based on your risk profile will ensure that you are not subjected to excessive levels of anxiety about the portfolio as its risk exposure will be managed.

Academics will continue to argue about the benefits of rebalancing and the optimum method of applying it but most agree that it is beneficial, especially for higher- growth-oriented portfolios. The impact of dealing costs means that it probably does not need to be carried out more than annually.

Some research suggests that for higher-growth portfolios, rebalancing when the assets fluctuate by 20 per cent or more in value can deliver a degree of performance enhancement. However, for lower- growth portfolios where a greater proportion is held in assets which are less volatile, the case for rebalancing is less clear cut.

On balance, the most pragmatic approach would be to review all portfolios at least annually and to consider rebalancing more frequently where asset classes change in value by more than 20 per cent.

Chris Wicks is director of N-Trust


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