By Mike Adsetts, Global Chief Investment Officer at Momentum Multi-Managers
As the saying goes, “the trend is your friend”, and when it comes to portfolio rebalancing approaches, there is a bit of truth to that! Momentum is one of the most powerful factors in investing and this is a useful point to start the conversation about rebalancing approaches.
There are simple mechanistic approaches where you rebalance to your strategic asset mix periodically or when there is a certain level of drift away from the desired longer-term asset mix. These approaches have advantages and drawbacks. Periodic rebalancing keeps your portfolio in shape at certain points in time, but does not take into account market circumstances in the interim periods or at the rebalance date.
Maintaining the ideal asset mix
Allowing for drift up to a certain level or trigger point does allow for harvesting of some of the outperformance of different asset classes before a rebalancing event occurs. What you need to be mindful of is how much you want your portfolio to drift away from the ideal asset mix. This has implications for the risk profile: Too broad a band could result in you having a less or more aggressive portfolio than you want, and too small a band will trigger frequent rebalances which can increase the costs. Some sophisticated variations of this will balance the cost of rebalancing against the extra return that you can harvest from the drift of the asset classes based on market movements. Ideally, you want to cover the costs and maybe a little extra from portfolio drift.
The approaches are not a guaranteed source of extra return, but they can add small amounts of incremental value over time.
Adjusting your tactical asset allocation
What both of these approaches don’t do is take a view of market conditions. They are rule-based approaches with the main objective of keeping the funds close to the desired exposure over time.
The next level of rebalancing is the realm of tactical asset allocation. Market conditions and factors such as the fundamental value of asset classes are taken into account, as well as a view on how things are expected to pan out over time. Mostly the top-down views would be macro-economic in nature and would consider reasonable events over the near to medium term.
Based on a view of whether an asset class is perceived to be under-valued or over-valued, the exposure would be adjusted to reflect this view. Depending on the confidence of the view the variation can be made bigger or smaller, although it is always useful to have limits in place. This will prevent excessive risk or conservatism being built into a portfolio. Tactical asset allocation is a bit of a combination of art and science, as there are always unexpected events that can derail the best-laid plans. This is an active approach that requires a high degree of vigilance and skill, together with a healthy dose of risk management and oversight.
The best solutions come from the professionals
This then is my quick take on portfolio rebalancing approaches. It can be applied at asset class or fund level, depending on your approach to constructing portfolios. A key consideration is the extent to which you want a rules-driven approach as opposed to one that incorporates active market views and positioning.
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