FT Guide to Exchange Traded Funds and Index Funds: How to Use Tracker Funds in Your Investment Portfolio (Financial Times Series) by David Stevenson

Author:David Stevenson [Stevenson, David]
Language: eng
Format: epub
ISBN: 9780273769422
Publisher: Pearson Education Limited
Published: 2012-12-14T00:00:00+00:00

Rebalancing

Remember that word discipline? A large part of the discipline of the investment process is not twisting and turning with the prevailing opinion but an equally large element consists of realising that portfolios need some care and maintenance via a periodic rebalancing. The process behind this concept is best understood with an example.

Assume you have a £100,000 portfolio nominally split with 50 percent invested in global short-dated bonds and 50 percent in global equities. After a year if equities have risen by 20 percent and the fixed interest by 5 percent, then the equity component would have risen to £60,000 and the fixed interest to £52,500 for a total of £112,500. The equities now make up a little over 53.3 percent of the portfolio and the fixed interest 46.7 percent. Now there is no real harm in that, but if returns continue in that manner then after five years the equities would be worth two-thirds of the overall portfolio. Again, you may think that is fine – the portfolio is growing well and providing excellent returns.

However, think back to earlier in this chapter. Investing is not simply about making money – it is about achieving goals. While letting a 50:50 portfolio simply run is likely to deliver the best long-run returns (as equities should outperform the volatility reducing fixed interest), this is not what we think the investment and planning process is about. Investing must be about managing risk. When the stock market suddenly falls by 25 percent in one year the unbalanced portfolio is clearly going to suffer much more. Although it may still be worth more, the journey getting there has been much more volatile.

While there has been much academic research on the subject of rebalancing there seems to be little consensus as to the best way to do it. On the one extreme, David Swensen, the legendary manager of the Yale endowment fund, rebalances on a daily basis. He argues that frequent rebalancing activity allows investors to maintain a consistent risk profile. Others argue that portfolios should be allowed to run for two or three years before rebalancing, citing the often quoted ‘the trend is your friend argument’. In other words, whatever direction the market is moving in at any time, it seems to have some momentum. Another solution is rebalancing on the basis of pre-defined tolerances, i.e when a particular asset class moves more than a pre-set amount then it is rebalanced back. In the penultimate chapter of this book, we’ll look in detail at each of these strategies, plus a few novel ideas. However, a simple compromise which works for most people is to review the portfolio annually and if the portfolio has not moved sufficiently do not make any changes. Where movements are more material then go ahead and make the changes.

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