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An Introduction to Understanding Variables in Rebalancing a Diversified Portfolio

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 Nicholas B. Rowe, CFP

July 2010

This Paper sets out several strategies and considerations the manager should be aware of when considering rebalancing a portfolio of diverse asset types. It does not intend to examine all variables effecting the rebalance decision nor does it purport to examine all approaches to rebalancing a portfolio.

 

The two primary variables to understand and incorporate in any investment policy are asset class modeling and rebalance strategy. Both will have varying affects on the overall portfolio risk and return characteristics. This paper will give a brief overview of these two variables.

 

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Asset Class Modeling within the Portfolio

 

The process of choosing the asset classes to include in the portfolio can range from simple to complex analysis of the various potential components. This process will result in a model portfolio. This discussion will not examine the process of modeling, but rather, briefly review some of the asset class options and how an adviser may approach this task.

 

It has long been understood to be possible to diversify a portfolio beyond the basic asset classes of cash, bonds and equity to change the risk and return characteristics of the portfolio. Examples of some of the more traditional choices the manger may look to, to broaden the scope of the basic portfolio include:

 

• Credit Quality (i.e. High Yield Bonds versus Government Bonds)

• Sectors (i.e. Transportation Index versus Oil Index)

• Market Cap (i.e. Small Cap versus Large Cap)

• Investment Style (i.e. Growth versus Value)

• Geographic Regions (i.e. Emerging Markets versus Domestic)

 

These can be mixed and matched or drilled down into subsectors (India would be a subsector of Emerging Markets for example). The adviser, after some examination may have discovered low correlation and increased alpha between the Small Cap Growth and Large Cap Value asset classes and therefore may decide to include them in the portfolio in place of an SP500 Index Fund in an effort to maximize return with out increasing the overall deviation of the portfolio (perceived as risk by most market participants).

 

It may be prudent to add other, less traditional, asset types to the above list. Some of these have become more popular in the last few years others may only be familiar to the astute adviser. The adviser may wish to include for example:

 

• REITs

• Precious Metals

• Commodities

 

As with the first group of asset classes these too may be drilled down into the sub sector level (Hotels would be a sub sector of REITs, Grains would be a subsector of commodities and still further down in the same sector, wheat would be a subsector of grains for example).

 

Then there are the alternative asset classes that can be considered by the adviser who has a grasp of more complex money management techniques, these include but are not limited to:

 

• Absolute Return Strategies

• Hedge Strategies

• Long / Short Strategies

 

Again there are sub categories and different twists to each of the top level alternative asset classes listed above that an advisor may wish to examine.

 

Not every one of the above “less traditional” asset types will be appropriate for the expertise level of every advisor, nor will each be appropriate for every client’s portfolio. But they should be considered as low correlated assets to the traditional portfolio that can potentially reduce risk and/or increase returns when used along with a prudent rebalance strategy.

 

 

The Rebalance

 

Once the asset classes have been examined for standard deviation and correlation characteristics, appropriate ones chosen and allocation amounts determined based on the clients needs, goals and risk profile, the next thing to address must be a policy for enacting the rebalance (the buy and hold approach will not be discussed here as an alternative to rebalancing as it has thoroughly been covered previously in numerous white papers and it is assumed every adviser understands the technique).

 

Many different methods are used for timing the rebalance. Even rebalancing based on a visit by the client is a distinct method or strategy. With this method a rebalance is done just before or after a client appointment. This no doubt is the least effective method for timing mechanism for the rebalance. An appointment the client has squeezed in between a visit to the CPA and dentist is unlikely to result in an optimum rebalance where managing risk and return are the chief concern. So let us now examine several different approaches to timing the rebalance:

 

Strategic

 

With a strategic rebalancing approach the adviser establishes each asset class to be in the portfolio and target percentages for each asset class. In principle the adviser will make periodic rebalance adjustments to restore the asset classes to their original target values. This requires selling asset classes that have grown more than the portfolio as a whole (or dropped less than the portfolio as a whole), and buying the asset classes that are under the original target allocation.

 

This can be done using one of several different strategies, some examples of rebalance triggers are:

 

• Periodic (rebalance is done at a specific periodic date on the calendar)

• Threshold (If a target allocation to an asset class is 40% but it has changed to 45% and the threshold is 4.5% a rebalance is required to return the asset to it’s target allocation)

• Volatility (rebalance is done based on the portfolio deviation changing beyond a threshold, or one or more of the asset classes in the portfolio deviating beyond a threshold, thus requiring a rebalance of the entire portfolio)

• Range (a target range for the asset class is predetermined, if the target is 20% the range is 3% and the security moves to either 25 or 15% the rebalance would be to the range not the target in this case either 23% or 17%, both final results are 3% away from the target. This method may result in less trading with similar risk return characteristics.

 

All of these methods can be applied to just two asset classes (for example in the case of one asset class exceeding its expected returns and another underperforming while the rest of the portfolio remains relatively in balance) or across the entire portfolio.

 

There are other rebalance methods that will not be discussed here. The reader is reminded that this is an overview not a comprehensive discussion of the issues addressed herein.

 

Tactical

 

The tactical approach requires the adviser adjust the allocation asset classes and/or percent weighting in the portfolio based on changed market or client conditions.

 

Examples of market events that may trigger a tactical adjustment to the portfolio and/or rebalance may be a short or long term change in market conditions such as:

 

• Interest rate changes

• Currency shifts

• Crisis events that may change the business environment for a time

• Opportunistic opportunities on a macro (regional) or micro (company) level

• Government policy changes

 

Client events that may trigger a tactical adjustment to the portfolio and/or rebalance are many and varied and is beyond the scope of this paper.

 

This paper has made the briefest of reviews of the approach to the choice of asset classes and rebalancing techniques. It is hoped that this will be just the first step to a greater understanding of these important variables in managing a diverse investment portfolio.

 

The reader is encouraged to further explore this subject. There are many white papers, reference works and articles dealing with varying aspects of asset allocation and rebalancing that will prove invaluable to the adviser as he/she creates a policy for managing client portfolios.

 

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Additional reference works, articles and white papers:

 

Reference Works/ Articles:

 

The Rewards of Multiple-Asset-Class Investing, by Roger C. Gibson, CFA, CFP® Journal of Financial Planning, March, 1999

 

The Importance of Portfolio Rebalancing in Volatile Markets, by Steven B.Weinstein, Cindy Sin-Yi Tsai and Jason M. Laurie

Retirement Planning/July–August 2003

 

Brave New World of Alternative Investing, Financial Advisor, March 07, 2008

White Papers:

 

Geometric Mean Maximization: An Overlooked Portfolio Approach?

Javier Estrada, IESE Business School, Avenida Pearson 21, 08034 Barcelona, Spain

 

Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes

David C. Blitz Deputy Head of Quantitative Strategies at Robeco Asset Management in the Netherlands

Pim van Vliet PhD Senior Researcher at Robeco Asset Management in the Netherlands

 

BEHAVIORAL ASSET ALLOCATION FOR FOUNDATIONS AND ENDOWMENTS

Steve P. Fraser and William W. Jennings1

U.S. Air Force Academy, June 2006

 

A Quantitative Approach to Tactical Asset Allocation

Mebane T. Faber, July 2006, Working Paper