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Now is the time to rebalance your equity portfolio
Study shows the rebalancing method outperforms the buy and hold method over a long period
THE recent volatility has taken investors for a wild ride. After starting the year on a strong note, within two weeks, many Asian markets have corrected 7 per cent to 10 per cent. This is a good time to be rebalancing your portfolio.
Rebalancing your portfolio involves setting a fixed portfolio allocation from the very start. So, for example, you set an allocation of 30 per cent into US equities, 30 per cent into Asia equities, 30 per cent into Europe equities, and 10 per cent into Japan equities.
Then, at the end of a fixed period like one year, markets would have moved differently. So, then you buy or sell whatever is needed until you have the exact same allocation again. And this exercise continues faithfully each year for as long as the portfolio is in existence.
Basically, what this forces you to do is to take profit from your best performing sectors/regions, and to invest more into the underperforming regions/sectors that year. It is a mechanical method that disregards what you think of markets.
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If bond funds are added into the mix, the volatility can be controlled even more, and rebalancing arguably works even better because bond funds in general have a very low correlation to equity funds.
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It works on the principle that no single market will ever be best performing all the time through the years, and neither will any single market ever stay down in the dumps every single year.
So, as the market cycles go through their rises and falls, the method will eventually result in you buying more of a market when that market is low, and selling some of the market that has gone up sharply. Thus, it ultimately results in an investor buying low and selling high, which is the recipe for a successful portfolio.
We have a long-running back test which we have been maintaining for nearly seven years now. This involves the concept of rebalancing. The rebalancing method has shown that over a long period of time (our back test is over 39 years), a portfolio that used the rebalancing method has outperformed passive buy and hold methods by a quite a large margin.
We have updated the numbers for 2009 based on the allocation mentioned above, and the backtested rebalanced portfolio has outperformed a similar portfolio that is just purely based on buying the original allocation and holding it over the last 39 years. As you can see from Table 1, after 39 years, the global portfolio managed using the rebalancing method had grown to $280,643, and this is $117,745 more than what the buy and hold portfolio ended up with. The difference is quite significant.
For reference purposes, we have also shown the MSCI World Index's performance alongside as well. The amazing thing is that when rebalanced with 20 per cent bonds, the result still ends up better than the buy and hold portfolio, but with less volatility.
Let's go into more detail about what actions rebalancing would have forced an investor to do in the last two years. The year 2008 was really bad when all markets fell heavily.
Even so, there were some differences. Asian markets in general fell more than developed markets like the US and Japan. Rebalancing forced us to take money out of US and Japan, which fell less than Asia in 2008, and put it into Asian markets at the end of 2008. Thus, in 2009, when Asian markets surged much more strongly than developed markets, the portfolio actually benefited.
Of course, the method may not always work well on a singular year basis. Especially if we have a market that goes through multiple years of a bull run or a bear run. However, for volatile years where there are big swings like what we experienced in 2008 and 2009, it generally works well.
If bond funds are added into the mix, the volatility can be controlled even more, and rebalancing arguably works even better because bond funds in general have a very low correlation to equity funds. (See Table 1 for how it fared.)
Rebalancing would have forced us to take money out from bond funds, and re-channelled some of it into our equity funds in 2008 when they were beaten down so much, and we would have then reaped the benefits of that in 2009 when equity markets surged. The returns are slightly lower over time as seen in Table 1, but the volatility of the portfolio is lower as well.
So, how do you actually rebalance a portfolio? We will now go over how we actually implemented this portfolio with the same allocation that we talked about. Our portfolio is made up of seven markets represented by their respective market indices. The four Asian markets add up to 30 per cent. See Table 2.
For our backtested portfolio, our initial allocation was US 30 per cent, Europe 30 per cent, Japan 10 per cent, South Korea 7.5 per cent, Hong Kong 7.5 per cent, Singapore 7.5 per cent, and Taiwan 7.5 per cent. We then started rebalancing it all the way from the start of year 1971 to end-2009, a period of 39 years.
From an initial portfolio of $10,000 at the start of 1971, the growth of the portfolio based on rebalancing and compared to a similar portfolio based on buying the same initial allocation and holding it all the way until end-2009 is shown in Table 1.
A lot of things happened in the last 39 years. We had two oil crises, the Asian financial crisis, the technology bubble bursting, and then more recently, the big crash in 2008 due to the sub-prime loans crisis in the US. Yet, through it all, the rebalancing method has performed well against the buy and hold method.
In conclusion, the rebalancing method has outperformed the buy and hold method when both were practised over the last 39 years. While it is not expected to outperform this index every single year, it has managed to do so frequently enough over a long period of time such that the improvement in a portfolio's gain is quite significant.
That is why investors who are reviewing their portfolio might wish to consider rebalancing if they want a disciplined method that works over the long term.
Wong Sui Jau is the general manager of Fundsupermart, a division of iFAST Financial Pte Ltd
By WONG SUI JAU
General manager of
Fundsupermart
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