Balanced Fund Bear Market and the benefits of Rebalancing

Balanced Funds are on track to experience one of their largest monthly losses on record.

Although this largely reflects the sharp and historical declines in global sharemarkets, fixed income has also not provided the level of portfolio diversification witnessed in previous Bear markets.

In the US, the Balanced Portfolio (60% Shares and 40% Fixed Income) is experiencing declines similar to those during the Global Financial Crisis (GFC) and 1987.

In other parts of the world the declines in the Balance Portfolio are their worst since the   1960s.

As you will be well aware the level of volatility in equity markets has been at historical highs.

After reaching a historical high on 19th February the US sharemarket, as measured by the S&P 500 Index, recorded:

  • Its fastest correction from a peak, a fall of 10% but less than 19%, taking just 6 days; and
  • Its quickest period to fall into a Bear market, a fall of greater than 20%, 22 days.

The S&P 500 entered Bear market territory on March 12th, when the market fell 9.5%, the largest daily drop since Black Monday in October 1987.

The 22 day plunge from 19th February’s historical high into a Bear market was half the time of the previous record set in 1929.

Volatility has also been historical to the upside, including near record highest daily positive returns and the most recent week was the best on record since the 1930s.

 

Volatility is likely to remain elevated for some time. The following is likely needed to be seen before there is a stabilisation of markets:

  • The Policy response from Governments and Central Banks is sufficient to prevent a deepening of the global recessions;
  • Coronavirus infection rates have peaked; and
  • Cheap valuations.

Although currently there are cheap valuations, this is not sufficient to stabilise markets. Nevertheless, for those with a longer term perspective selective and measured investments may well offer attractive opportunities.

Please seek professional investment advice before making any investment decision.

For those interested, my previous Post outlined one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

 

The Impact of Market Movements and Benefits of Rebalancing

My previous Post emphasised maintaining a disciplined investment approach.

Key among these is the consideration of continuing to rebalance an investment Portfolio.

Regular rebalancing of an investment portfolio adds value, this has been well documented by the research.  The importance and benefits of Rebalancing was covered in a previous Kiwi Investor Blog Post which may be of interest: The balancing act of the least liked investment activity.

Rebalancing is a key investment discipline of a professional investment manager. A benefit of having your money professionally managed.

Assuming sharemarkets have fallen 25%, and no return from Fixed Income, within a Balanced Portfolio (60% Shares and 40% Fixed Income) the Sharemarket allocation has fallen to 53% of the portfolio.

Therefore, portfolios are less risky currently relative to longer-term investment objectives. A disciplined investment approach would suggest a strategy to address this issue needs to be developed.

 

As an aside, within a New Zealand Balanced Portfolio, if no rebalancing had been undertaken the sharemarket component would have grown from 60% to 67% over the last three years, reflecting the New Zealand Sharemarket has outperformed New Zealand Fixed Income by 10.75% per year over the last three years.

This meant, without rebalancing, Portfolios were running higher risk relative to long-term investment objectives entering the current Bear Market.

Although regular rebalancing would have trimmed portfolio returns on the way up, it would also have reduced Portfolio risk when entering the Bear Market.

As mentioned, the research is compelling on the benefits of rebalancing, it requires investment discipline. In part this reflects the drag on performance from volatility. In simple terms, if markets fall by 25%, they need to return 33% to regain the value lost.

 

Investing in a Challenging Investment Environment

No doubt, you will discuss any current concerns you have with your Trusted Advisor.

In a previous Post I reflected on the tried and true while investing in a Challenging investment environment.

I have summarised below:

 

Seek “True” portfolio Diversification

The following is technical in nature and I will explain below.

A recent AllAboutAlpha article referenced a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

For the professional Investor this Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

 

We are currently experiencing a Black Swan, an unexpected event which has a major effect.

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits over the longer term and particularly at time of market crisis.

True portfolio diversification is achieved by investing in different risk factors (also referred to as premia) that drive the asset classes e.g. duration (movements in interest rates), economic growth, low volatility, value, and market momentums by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market risk (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative, and hedge fund risk premia. And of course, “true alpha” from active management, returns that cannot be explained by the risk exposures just outlined.

There has been a disaggregation of investment returns.

US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.

 

Therefore, seek true portfolio diversification this is the best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates to drive portfolio outcomes.  As the Deutsche Bank Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events e.g. Black Swans.

True diversification leads to a more robust portfolio.

 

Customised investment solution

Often the next bit of  advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from investment markets.

For example, level of income earned up to retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

Also look to financial planning options to see through difficult market conditions.

 

Think long-term

I think this is a given, and it needs to be balanced with your investment objectives as outlined above.

Try to see through market noise and volatility.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

Remain disciplined.

 

There are a lot of Investment Behavioural issues to consider at this time to stop people making bad decisions, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwi Investor Blog is all about education, it does not provide investment advice nor promote any investment, and receives no financial benefits. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all-weather portfolio?

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

The balancing act of the least liked investment activity

A recent Research Affiliates article on rebalancing noted: “Regularly rebalancing a portfolio to its target asset mix is necessary to maintain desired risk exposure over the portfolio’s lifetime. But getting investors to do it is another matter entirely—many would rather sit in rush-hour traffic! “

“A systematic rebalancing approach can be effective in keeping investors on the road of timely rebalancing, headed toward their destination of achieving their financial goals and improving long-term risk-adjusted returns.”

Research Affiliates are referencing a Wells Fargo/ Gallup Survey, based on this survey “31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios. Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio?

 

I can’t understand why rebalancing of an investment portfolio is one of least liked investment activity, it adds value to a portfolio overtime, is a simple risk management exercise, and is easy to implement.

It is important to regularly rebalance a Portfolio so that it continues to be invested as intended to be.

 

A recent article in Plansponsor highlighted the importance of rebalancing. This article also noted the reluctance of investors to rebalance their portfolio.

As the article noted, once an appropriate asset allocation (investment strategy) has been determined, based on achieving certain investment goals, the portfolio needs to be regularly rebalanced to remain aligned with these goals.

By not rebalancing, risks within the Portfolio will develop that may not be consistent with achieving desired investment goals. As expressed in the article “Participants need to make sure the risk they want to take is actually the risk they are taking,” …………..“Certain asset classes can become over- or under-weight over time.”

Based on research undertaken by BCA Research and presented in the article “Rebalancing is definitely recommended for all investors, perhaps more so for retirement plan participants than others, as they are more likely to be concerned with capital preservation than capital appreciation.”

The following observation is also made “While a portfolio that is not rebalanced will have a greater allocation to equities during a bull market and, therefore, outperform a rebalanced portfolio, all rebalanced portfolios outperformed an unbalanced portfolio during periods leading up to market corrections and recessions,” Hanafy says, citing a BCA Research study which looked at three main rebalancing scenarios of a simple 60/40 portfolio since 1973.

The potential risks outlined above is very relevant for New Zealand and USA investors currently given the great run in the respective sharemarkets over the last 10 years.

When was last time your investment fiduciary rebalanced your investment portfolio?

 

Rebalancing becomes more important as you get closer to retirement and once in retirement:

“There are two main components to retirement plans: returns and the risk you take,” …… “When you do not rebalance your portfolio, a participant could inadvertently take on too much risk, which would expose them to a market correction. This is important because, statistically, as participants reach age 40 to 45, how much risk they take on is far more important than how much they save. When you are young, the most important thing is how much you save.”

Rebalancing Policy

As the article notes, you can systematically set up a Portfolio rebalancing approach based on time e.g. rebalance the portfolio every Quarter, six-months or yearly intervals.

It is not difficult!

Alternatively, investment ranges could be set up which trigger a rebalancing of the portfolio e.g. +/- 3% of a target portfolio allocation.

Higher level issues to consider when developing a rebalancing policy include:

  • Cost, the more regularly the portfolio is rebalanced the higher the cost on the portfolio and the drag on performance. This especially needs to be considered where less liquid markets are involved;
  • Tax may also be a consideration;
  • The volatility of the asset involved;
  • Rebalancing Policy allows for market momentum. This is about letting the winners run and not buying into falling markets too soon. To be clear this is not about market timing. For example, it could include a mechanism such as not rebalancing all the way back to target when trimming market exposures.

 

My preference is to use rebalancing ranges and develop an approach that takes into consideration the above higher level issues. As with many activities in investing, trade-offs will need to be made, this requires judgement.

 

As noted above, it appears that rebalancing is an un-liked investment activity, if not an over looked and underappreciated investment activity. This seems crazy to me as there is plenty of evidence that a rebalancing policy can add value to a naïve monitoring and “wait and see” approach.

I think the key point is to have a documented Rebalancing Policy and be disciplined in implementing the Policy.

 

This also means that those implementing the Rebalancing Policy have the correct systems in place to efficiently carry out the Portfolio rebalancing so as to minimise transaction costs involved.

Be sure, that those responsible for your investment portfolio can efficiently and easily rebalance your portfolio. Importantly, make sure the rebalancing process is not a big expense on your portfolio e.g. trading commissions and the crossing of market spreads (e.g. difference between buy and sell price), and how close to the “market price” are the trades being undertaken?

These are all hidden costs to the unsuspecting.

 

A couple of last points:

  • It was noted in the recent Kiwi Investor Blog on Behaviour Finance that rebalancing of the portfolio was an import tool in the kit in helping to reduce the negative impact on our decision making from behavioural bias. It is difficult to implement a rebalancing policy when markets are behaving badly, discipline is required.
  • The automatic rebalancing nature of Target Date Funds is an attractive feature of these investment solutions.

 

To conclude, as Research Affiliates sums up:

  1. Systemic rebalancing raises the likelihood of improving longer-term risk-adjusted investment returns
  2. The benefits of rebalancing result from opportunistically capitalising on human behavioural tendencies and long-horizon mean reversion in asset class prices.
  3. Investors who “institutionalise contrarian investment behaviour” by relying on a systematic rebalancing approach increase their odds of reaping the rewards of rebalancing.

 

It is not hard to do.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.