InvestorQ : Sir, I am told that regular rebalancing of portfolio is essential. Can you tell me what is rebalancing and how to do rebalancing of the portfolio?
Mahima Roy made post

Sir, I am told that regular rebalancing of portfolio is essential. Can you tell me what is rebalancing and how to do rebalancing of the portfolio?

Aditi Sharma answered.
2 years ago

To understand portfolio management and financial planning, you need to thoroughly understand the crux of portfolio rebalancing because that is normally the gap between success and failure. When you create your portfolio to achieve your medium term and long term goals, it is not exactly a static portfolio. The asset allocation needs to be regularly reviewed in the light of changes in your own risk-return matrix and also in terms of changing market conditions. The portfolio review must happen at least once a year and based on the triggers your portfolio must be rebalanced. Year 2019 is likely to be a year of domestic and global triggers which include the general elections, US Fed action, and outcome on BREXIT etc.

Rebalancing ensures that the investment mix is aligned with long term goals and objectives. With the passage of time your return requirements change, your risk profile changes, there are new investment opportunities and asset classes may either outperform or underperform. All these call for rebalancing of your portfolio. The question, therefore, is what should be the triggers for rebalancing and how exactly to go about it. Let us look at some interesting ways of rebalancing your portfolio in calendar year 2019.

Don’t lose sight of your original master allocation

This is the most common form of rebalancing based on your original asset allocation. As a young executive at the age of 30, you may start off with a master allocation of 60:30:10 in favour of equity, debt and liquid funds respectively. Such allocations cannot be static so you normally set a range of (+/- 5%) as acceptable. As part of your regular portfolio review, whenever the 5% mark is breached either ways it is a trigger to rebalance your portfolio and revert to the master allocation. For example, if your equity allocation has gone up to 68% due to a bull run in equities, it is a trigger to bring equities back to its original allocation. The only challenge in this approach to rebalancing is that it is a mechanical approach.

Rebalance based on shifting trends

This is a more dynamic and hence complicated approach to rebalancing. In this case, you rebalance based on key trends in the market. For example, in a rising interest scenario it may be more meaningful to shift from long duration bonds to short duration bonds. The reverse holds in a falling interest scenario. After a sharp correction in stocks (as we saw in 2009 and 2013), equities may be available at low valuations. That calls for rebalancing in favour of equities. Gold as an asset class performs well in times of geopolitical uncertainty. Escalating geopolitical crisis in the Middle East or a Euro crisis could make gold the preferred safe haven. It calls for a greater allocation to gold, albeit temporarily.

Passive rule-based approach can also be used at a macro level

Based on empirical testing of data, you can also set themes and rules for rebalancing. You can set a rule that if Nifty P/E goes above 22X, you reduce your equity allocation by 5% and if P/E goes below 16X, you reduce equity allocation by 5%. You can also set a threshold for benchmark yields. For example, if yields go up 2% above the mean rate, you shift 20% of the short dated portfolio to long dated portfolio. You can apply the reverse rule in case of fall in yields. If you take the VIX as a proxy for volatility, you can set rules like you will increase allocation to gold if VIX crosses 25.

Using expert managerial discretion for rebalancing

This expert managerial view has two sub-interpretations. You can use expert discretion to pre-empt a sharp fall in asset values. Alternatively, you can also use an active approach wherein you identify big opportunities in advance and temporarily rebalance to make the best of the trend. Sectoral and thematic shifts are illustrations of this type of rebalancing. Here you dynamically shift your portfolio between equity and debt based outlook. There are two things to bear in mind here. Firstly, aggressive rebalancing has a cost in terms of transaction and statutory costs as well as lost opportunities. Also regular rebalancing can be tax-inefficient.

You can also rebalance to make the portfolio tax efficient

It is an accepted axiom that rebalancing of your portfolio should not be purely driven by tax considerations alone. But there are times, when tax becomes a major issue and calls for rebalancing. Let us look at 2 such situations where tax efficiency can call for rebalancing.

Dividend Distribution Tax (DDT) on equity funds makes it smarter to rebalance and shift from dividend plans to growth plans. In case of debt funds, your portfolio structure can be shifted from dividend plans to growth-plan based SWPs.

With the falling yields on Section 80C investments like PPF and NSC, investors can look to shift to ELSS for tax saving *** wealth creation. Regulatory shifting of small savings from EEE to EET may trigger rebalancing. One can also book losses for loss-farming.

That is how rebalancing of portfolio is done. Ideally, this rebalancing is done on a need basis but portfolio review is something that must be done on an annual basis. Whether that results in actual rebalancing or not is something that has to be determined on a case by case basis.