When you hear “rebalancing” in an investment context, one may immediately think of trimming back stocks that have outperformed and taking the opportunity to reallocate these funds to stocks that have pulled back. This helps to mitigate concentration risk, or the risk that you have too much of a given holding. What is also important when rebalancing is to assess current market conditions, and not just individual positions. Rebalancing is certainly a time to reposition back to the target asset allocation, but it is also a time to take a big picture view and assess other market conditions at play and see what opportunities are available.
Rebalancing frequency
The question is always whether investors should rebalance quarterly, semi-annually, or annually. Over the years several studies have been done to determine the frequency with which you should rebalance your portfolio. As the markets vary from year to year, the frequency should be adjusted based on current conditions. Rebalancing asset mix and individual position size can normally be done at the same time. We believe that rebalancing to your optimal asset mix should be done at least once a year.
January is generally a good month to rebalance portfolios, especially if the investments are non-registered. Individuals who realize gains in January will be able to defer the tax at least one year. January has also historically been a positive month in the markets. If all your investments are within registered plans, such as a Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP), or Registered Retirement Income Fund (RRIF), then you can effectively pick any month of the year. Keeping up to date on current market conditions and routinely monitoring your portfolio will determine if this should be done more frequently.
Prior to rebalancing, it is important to periodically review your Investment Policy Statement (IPS) to ensure that you’re comfortable with the asset mix. Changes in market conditions, foreign exchange rates, and interest rate outlook are factors to discuss with your Portfolio Manager when revising the asset mix within your IPS. Your personal goals, your current and future needs for cash, and knowledge level may also result in your optimal asset mix needing to be adjusted. Let’s look at each of these aspects in further detail.
Market conditions
For investors with longer-term time horizons, fluctuations in the markets may provide an opportunity to purchase or sell investments. Current market conditions do play a very important role in rebalancing. Let’s say an investor has $1,500,000 in a moderate growth portfolio with 20 per cent (or $300,000) allocated in fixed income and 80 per cent (or $1,200,000) allocated in equities.
For example, say the equity markets have been strong and the portfolio increases to $1,700,000. Periodically we would have rebalanced by selling a portion of equities and always maintaining the fixed income at 20 per cent. In this case, assuming all other market conditions are equal, we would sell $40,000 of equities and increase fixed income by $40,000.
Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk. Rebalancing also helps smooth out volatility over time.
If, for example, the equity markets decline then we will do the exact opposite for our clients. We would sell some of the fixed income, which would then be overweight, and buy equities at the lower level. Our client’s IPS will also permit a range to temporarily underweight or overweight either cash, fixed income, or equities.
Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.
Clients who have a moderate growth portfolio have an optimal fixed income set at 20 per cent. The IPS enables the moderate growth portfolio to have as low as zero per cent in fixed income or as high as 40 per cent. Clients who have a balanced growth portfolio have an optimal fixed income component set at 40 per cent. The IPS enables the balanced growth portfolio to reduce fixed income to as low as 20 per cent and as high as 60 per cent.
These ranges are meant to assist clients who wish to temporarily increase equities when opportunities are available. The greater the decline in the equity markets, the more consideration should be put on underweighting fixed income temporarily. One of the benefits of working with a Portfolio Manager is the ability to talk through these options during periods of volatility.
Foreign exchange rates
Part of having a diversified portfolio is having foreign investments. We believe that by having foreign investments, you open yourself up to the opportunity to invest in the best companies worldwide, and not just within 乌鸦传媒. As Canadians, we pay our bills in Canadian dollars and need to consider currencies when determining real returns. As a result, one of the main risks to foreign investments is currency fluctuations; however, this can also be an advantage if you seize the opportunity of a weakened US dollar. There is an interesting relationship between the US dollar and equity markets that helps to smooth some of the volatility for Canadians invested in the equity market.
When markets start to become rocky, the US dollar is thought of as a safe haven for investors to put their money. Some investors sell out of the declining equity market, and purchase US dollars; causing the US dollar to rise. Oftentimes the rising US dollar helps to offset the declining equity markets. The same is true of the opposite – when the markets recover, investors may reduce their US dollar exposure. The rising equity markets helps to offset the decline in the US dollar, thereby smoothing the volatility of the investor’s real returns once converted to Canadian dollars.
Interest rate outlook
With the inverse relationship between fixed income and interest rates, it’s important to assess the interest rate outlook when rebalancing your portfolio. For example, if you are a balanced growth investor, you may have a target of 40 per cent fixed income in your portfolio. However, if interest rates are forecasted to rise, then fixed income prices will fall, and it could be an optimal time to consider reducing the portion of fixed income in your portfolio (down to 20 to 30 per cent) and increasing the portion of equities.
It may also be prudent to rebalance the duration of your fixed-income portfolio. The longer the term of a fixed income instrument, the more its price will fluctuate based on changes in interest rates; whereas a short-term fixed income instrument will see less exposure to such changes. There is a trade off with this as long-term fixed income instruments typically offer a higher yield than their short-term counterparts.
Future cash flow needs from the portfolio
Rebalancing can be a perfect time to assess your own upcoming cash flow needs from your investment portfolio. Our clients all have an IPS that outlines their cash flow needs for the portfolio. Once their cash flow needs are determined, we set up what we refer to as a “wedge” in money market and fixed income to earmark funds for the required cash flow. We do this with every client to ensure that when markets decline, we are selling cash equivalents and short-term fixed income. We are never forced to sell equities at the wrong point in the market cycle. This approach is essential for those individuals living off their investments.
As an example, a client may have a monthly systematic withdrawal plan (we call this a SWIP) to pull $6,000 per month ($72,000 annually) from their investments to fund their day-to-day expenses. This same client has communicated that they may need $60,000 for a new vehicle in the next 18 months. When this is communicated to us then we would have a wedge of at least $132,000 in a combination of Bank of Nova Scotia High Interest Savings Account and iShares Canadian Short-Term Bond Index.
Tax considerations
When a client opens new accounts, or makes significant deposits and withdrawals, then this is an ideal time to look at all levels of rebalancing. Even with smaller deposits into a RRSP or TFSA account it may be a good time to rebalance. In some situations, certain investments have better tax characteristics in different accounts. For example, we try to place interest bearing investments and those that pay other income (i.e. foreign income) within an RRSP/RRIF. Investments that generate capital gains and obtain the dividend tax credit are often better situated within a non-registered account.
Other rebalancing considerations
A more complicated component of the rebalancing process looks at geographic and sector exposure. Often investors will have no clear benchmark at the beginning to assess the geographic and sector exposure. Without these parameters outlined at the beginning it is more challenging to have a disciplined approach to rebalancing. Professional judgement and current conditions often move the benchmark of how funds are invested. Foreign exchange and interest rates, political news, government policies and other factors can determine geographic and sector weightings.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email [email protected] and visit .
