How to rebalance your portfolio out of COVID-19

As the Australian Stock Exchange (ASX) exits the recent 11 week bear market alongside the lifting of the most severe of restrictions imposed across Australia, now is probably a good time for investors to ask the question of themselves and consider whether rebalancing was something they did or should have considered.

If your growth asset component shrank significantly with the fall in share values, while your defensive assets, such as bonds and cash rose, did you act and rebalance and therefore are now seeing the benefit of the rebound in shares.

During one of the shortest and sharpest bear markets in history, having the discipline to rebalance, which many would liken to catching a falling knife, is easier said than done. However, when investing for the long term, executing a disciplined rebalancing strategy during such times keeps the risk of your portfolio aligned with your goals and risk tolerance, and positions you for an eventual recovery, improving long term results.

For some, the plunge into bear territory may have been too much to take, and instead of buying equities to align your allocation with your intended strategy, you may have lost your nerve and sold. This could be a trigger to reconsider your risk tolerance, as these events will inevitably occur and can't be predicted with confidence, even by the professionals.

If you were in the camp with a reasonably long-term investing horizon, you might ask why a rebalance is necessary and why now?

Over time, most notably after a prolonged period of volatility resulting from the ongoing health pandemic, asset classes produce different returns that change the portfolio's asset allocation. By periodically rebalancing, you reduce the tendency for 'portfolio drift', which aligns the risk of your portfolio that of your target asset allocation and therefore retain your desired level of diversification.

So how should you go about rebalancing your portfolio?

At its core, the aim of a rebalancing strategy is to align portfolio risk to the level you feel is appropriate. It is a deliberate action that you take to ensure that your portfolio continues to align with your investment goals and expected risk tolerance. You should be mindful that over the long term, the goal of a rebalance is not to maximise returns, but rather assess if the portfolio's expected performance is running parallel to the risk you are willing to take on.

Thus going back to your goals and risk appetite is the first step. Are the short, medium and long term financial goals you initially defined still relevant to your current circumstances? Are you comfortable that the investments you put in place to achieve these goals will endure if we were to encounter further market volatility should a resurgence of coronavirus hit Australia and beyond?

Next, assess if your portfolio is diversified across not only asset classes but also geographies. Has the equities portion of your portfolio shrunk because of the bear market and are you now overweight in bonds or cash?

Rebalancing in a prolonged bull market typically involves selling the outperforming assets (equities) and reallocating to lagging ones (bonds). In a bear market, the action required will almost certainly be the reverse, to reallocate funds to equities when they dive so as to be well positioned to benefit when the market bounces, as we have observed.

The end result you want is a portfolio that is broadly diversified across asset classes, industry sectors and where possible, geographies, and an investment strategy that will endure in both the boon of a bull market and the stress of a bear market.

An important thing to note before embarking on this process is to first identify how far your portfolio has drifted from its original allocation. Vanguard research found that if the drift is insignificant and within a few percentage points of the original allocation then the costs of rebalancing – such as buy/sell spreads, brokerage, capital gains taxes – are likely to outweigh the benefits of rebalancing. That said, a rebalanced portfolio is more likely to closely align with the characteristics of the target asset allocation than a portfolio that is never rebalanced.

For professionally managed diversified funds and ETFs, the regular cashflows contributed by a broad investor base allow for more frequent and cost effective rebalancing, while scale benefits can also warrant trading more frequently during volatile periods, to keep the funds closely aligned and capitalise on the lower trading costs that come with scale.

Professionally managed funds can also have the latitude to adapt the strategy for the market environment and monitor portfolio positions on a daily basis, though for an individual, a disciplined rule that can be adhered to consistently is likely to be the best approach to take.

Simple rebalancing rules can comprise either a time or threshold rule. A time rule simply means that a set period is established such as quarterly, semi-annually or annually where your asset allocation is rebalanced back to target. A threshold rule is one where you actively monitor your allocations and rebalance back when your asset exposures are a certain distance away from your target, such as a range of 5%. A combination of the two whereby positions are monitored quarterly, but trading only occurs if a threshold is breached is an effective way to combine the two and minimise the trading costs that come from rebalancing too frequently.

Vanguard research has found that for portfolios supporting long term goals, the exact time and threshold limits you decide upon are less important than the discipline of adhering to a consistent approach. Striking a balance that keeps your portfolio broadly aligned with your target asset allocation, while ensuring you aren't trading too frequently and racking up costs will see you well placed to achieve your goal.

Vanguard Australia

An iteration of this article was first published in the Australian Financial Review on 1 June 2020