Investment Comment
15th September 2023
Portfolio rebalancing and its quirks
With the summer drawing to a close, this week’s note moves away from the usual economic discussion to take a look at one of the technical aspects of the investment industry: portfolio rebalancing. Beware, mathematics is involved.
Portfolio rebalancing, which has multiple uses, is the buying and selling of assets to maintain a portfolio’s desired asset allocation. Its primary purpose is to keep a portfolio within its risk boundaries. If high-risk assets consistently perform well, then they become a larger part of the portfolio and therefore increase the portfolio’s overall risk. But rebalancing resets the portfolio back to the original asset allocation, maintaining the portfolio’s objective.
As a process, rebalancing has a number of quirks worth being aware of - the main one being its effect on performance. In the example below we show a two-stock portfolio (but the theory works just as well for a multi-asset portfolio i.e. a bond and equity mix), which starts out as equally weighted at the start of year 1, and which is left unchanged after year 1 (Scenario 1), compared to a rebalanced portfolio which is equally weighted.
In both scenarios, Stock A falls 20% in year 1 and then returns 25% in year 2, and Stock B rises 10% in year 1 and then falls 9.09% in year 2. The unmanaged portfolio returns to the start value of £200. In Scenario 2: by restoring the stocks to the original weight (or balance) at the end of year 1, despite the stocks moving the same as in the first example, the client ends up making a positive return of £5.
Comparing outcomes of a 2 stock portfolio: unmanaged and rebalancing
Source: Artorius
Mean reversion
This example only works when stocks revert back to their original price. If both stocks were to repeat their first-year performance the rebalanced portfolio would have lost out. So why then does Artorius rebalance portfolios if, performance-wise, it doesn’t always work out in the investor’s favour?
We rebalance portfolios because of mean reversion. This is the idea that, in financial markets, over time extreme events or outliers tend to move towards the average - meaning that a rebalanced portfolio typically outperforms one that has been left alone.
Obviously, if last year’s outperformers are expected to continue to outperform, then the investment manager may reshape the original asset allocation by adjusting the portfolio to reflect higher expected future returns. However, long-term cycles suggest that outperformance is temporary in many, if not most cases, and rebalancing back to the original portfolio design is beneficial.
When to rebalance?
Research shows there is no perfect time to rebalance, so any performance gain or loss derived from a rebalance is down to good market timing or, more likely, just luck. For Artorius’ discretionary managed portfolios, we use our internal software to review portfolios monthly and rebalance any that have drifted beyond our internal boundaries. We aim to only rebalance those portfolios that need it and therefore look to take advantage of any potential gains.
In conclusion, portfolio rebalancing isn’t just something that should be used on multi-asset portfolios by professional investors. Instead, it is a strategy that any investor should use on portfolios with multiple holdings to encourage discipline and maintain asset allocations and risk-tolerance levels to achieve long-term goals.
Economic and market review
The weakening of the global economic backdrop continued, with European and US economic data showing ongoing weakness. The biggest downward surprise was in the UK, where economic growth fell sharply in July, with a combination of wet weather and strikes contributing to a contraction. The UK housing market continued to be weak as evidenced by falls in house prices and a lack of new buyers as recorded by the Royal Institute of Chartered Surveyors. Despite the downbeat data and the rise in oil prices (as noted in last Friday’s comment) equity markets have staged a small rally this week, ironically on the back of weak data raising hope that interest rates may not need to rise further. Given the backdrop of oil prices increasing to nearly $90, the rally suggests that investors are banking on the inflation pulse from the increase in the oil price being tolerated by Central Banks, and assuming that the policymakers will not raise interest rates as a result.
All expressions of opinion reflect the judgment of Artorius at 15th September 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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