Coronavirus Induced Market Volatility: Should You Be Rebalancing Your Portfolio and How
Most savvy investors have a predetermined asset allocation for their portfolio based on the appropriate level of risk for their goals and situation. It is expressed in the investors Investment Policy Statement. That risk is usually designated by a percentage of equities (stock holdings) and the balance of the portfolio in fixed income (Cash and Bonds). As an example, this is often expressed as a 60/40 or a 80/20 allocation, where the first number indicates the percentage of overall equities (US stock, foreign stock, emerging markets stock, REITs etc.) and the second number percentage of fixed income.
Overtime, as markets change, the target allocation will change. This happens in normal market cycles but to a greater extent with more dramatic market swings, as we have recently experienced.
Rebalancing the portfolio is simply selling the asset classes that are over allocated as a result of market changes and buying those that are under allocated, in order to maintain the proper risk level. This means selling the asset classes that have done well and buying those that have not.
There are some factors to consider when rebalancing. The first is the trading costs to sell and buy securities, which will take a small bite. Another is possible taxes due to the selling appreciated securities in a taxable account. Then there is the time factor to review, analyze and complete the trades, which is not an issue when you have engaged an advisor to do this for you.
Rebalancing can be done in one of several methods
1) Rebalance based on “Time”, which could be once a year, semi-annual, quarterly or monthly.
2) Rebalance based on “Threshold”, when an asset class has changed by a determined percentage. (The same could apply to sub asset classes.)
3) Rebalance based on “Time and Threshold”. In other words, at the end of every time period, look at the allocation but only change the portfolio if the threshold of deviation (5%, 10%, 20 % 50%) has occurred.
4) Rebalance based on “Other”. This could mean “Whenever I get to it or think about it” or, “After a major market event (crash or gain)”.
In November of 2015 Yan Zilbering; Colleen M. Jaconetti, CPA, CFP®; Francis M. Kinniry Jr., while working for Vanguard, published a research paper on rebalancing. Over long time frames (1926 to 2015), analysing the first three options, they stated “after taking into consideration reasonable expectations for return patterns, average returns, and risk, we concluded that for most broadly diversified stock and bond portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produced a reasonable balance between risk control and cost minimization.”
In the most recent coronavirus induced market sell off, which has shown the fastest down market in our lifetime, let’s take the example of a young person with a 80/20 allocation on 1/1/2020. With the market changes, as of 3/19/20, if no, rebalance took place, (s)he would have an allocation of 51/49. It is well known that in order to be in the best position to take advantage of the recovery, returning to the proper allocation is crucial.
Using the Vanguard method of “Time and 5% threshold”, rebalancing at this point in time would not have occurred since the drop did not include the first of the year nor the ½ year nor a quarter. So, while their research showed the time and threshold method works over long term it would not have produced any rebalance at this time. A rebalance would take place at the end of June or December.
If on the other hand, the portfolio had been rebalanced with the threshold only of 5% or 10%, bonds would have been sold and more equities would have been bought. With reduced bonds and more stocks, the result would be more losses (as the equities continued to go down) than if there were no rebalancing took place. The smaller the threshold trigger the worse it would be. In whatever case, the pure threshold approach with small deviations would have hurt the portfolio in this sharp down market than if no rebalance took place. With larger thresholds of 20%, 35% or 50%, may or may not have triggered a rebalance. The larger the threshold the less the loss as stocks continue to slide.
If you were to use the “time only” methodology to rebalance, it would not have occurred since the end of the year, semi-annual, or quarter had not occurred. If you did rebalance on a monthly basis, you would be worse off than if no rebalance had occurred.
This brings us to the “Other” category of rebalance. The “get around to it” is not a good idea since most folks are busy and the often result is a long term Buy and Hold with no rebalance. This has been shown to lead to a slower recovery after a market turn down and to excess risk over time.
The remaining “other” option is to rebalance back to the proper allocation at the end, or near the end of a down market. The difficulty with this option is predicting when the bottom or near the bottom occurs.
In the case of the current coronavirus situation, there remains much uncertainty and markets do not like uncertainty. As a result, many feel there is a greater possibility that markets can go lower or stay down sooner than they will go up. Therefore, rebalancing at this time could lead to more losses than possible gains.
The course of the coronavirus and how the markets react is not a function of time (annual, semi- annual or quarterly) nor is it impacted by how the markets change (threshold). Therefore, it makes most sense to do a rebalance as a bottom to the markets appear to be forming. How to determine that is difficult for a professional and more difficult for an individual investor. The one thing that is known, is that a rebalance should take place prior to a market recovery.
So, the question is what is the best methodology to rebalance?
To address this, we should consider what happens in different markets. As a simple example, look at a 60/40 allocation made up of three Vanguard mutual funds. Vanguard Total Stock Market, 40%, Vanguard Developed Markets 20%, and Vanguard Total Bond Market 40%. We will look at five timeframes and how each of the rebalancing options will result in total returns over the time frames.
1) A big down market from 1/1/08 to 3/1/09,
2) A more complete cycle (down then back up) from 1/1/08 to 12/30/11
3) An up market from 1/1/12 to 1/1/20
4) Long term, 1/1/08 to 3/19/20
5) The current down market from 1/1/20 to 3/19/20
Out come from Kwanti software
VTSMX 40%, VTMGX 20%, VBMFX 40%
1/1/08 to 3/1/09
1/1/08 to 12/30/11
1/2/12 to 1/1/20
1/1/08 to 3/19/20
1/1/20 to 3/9/20
Trigger Rebalance at 50%
Trigger Rebalance at 25%
Trigger Rebalance at 20%
Trigger Rebalance at 10%
The above % are the total return (gain or loss) over the stated time frame. Out comes could be different with different asset classes, different securities and time frames.
What is evident from this limited review is that frequent rebalancing (Monthly Rebalance) is disadvantageous for portfolio returns in all time frames listed. Threshold rebalancing with wider deviation triggers (Trigger Rebalance at 50%) provided better returns in all time frames listed above, but can lead to periods of portfolio allocation much different from the goal allocation.
The IPS for all our clients addresses rebalancing from 2 perspectives:
Your portfolio will typically be rebalanced if the percentage of an asset class exceeds a plus or minus 20% deviation from the target allocation. Example: if the asset class allocation target was 10%, a rebalance will take place if the allocation exceeded 12% or is less than 8%.
The portfolio would also be rebalanced if the stock or fixed income allocation were more than 5% off the target allocation. Example: if the stock allocation was targeted at 60%, a rebalance would occur if the percentage of stock was over 65% or under 55%. In some cases, due to the magnitude of capital gains tax that would occur with a rebalance, the portfolio allocation may be allowed to exceed these limits. We will consider taxes and trading costs carefully before rebalancing.
The pivotal word is typically. We are not experiencing “typical” with the fastest down trend in the stock markets during our lifetime. Many clients have exceeded the 5% threshold of deviation from target stock allocation and for many we have not completed a rebalance fearing that the markets could go lower before they recover.
Therefore, perhaps the best rebalance option is to stick to the rebalance option as is in your IPS, but to suspend the rebalancing in a sharply down market (like now) but to BE SURE to rebalance prior to a market recovery. We will complete the rebalance when the coronavirus news stops being so bad and negatively impacting the markets. When it looks like the sharp drops stop, we will rebalance so that clients will be in a good position to take advantage of the recovery that we know will come.