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Portfolio drift and the upside of automatic rebalancing

Alistair Wilson, 19 December 2019

Re-balancing exists because even simple portfolios can drift from their target asset allocation, but should this be done manually or automatically, and how can a platform help?

Portfolio 1000x500

Once the goals have been agreed and all the risk assessments undertaken, the design of an investment portfolio for a client usually boils down to a set of percentages.

These start off with asset class allocation, then are further broken down by sector and finally by chosen funds.

It all has a neat, scientific appearance, often down to two places of decimals of allocation. But those precise percentages exist only on the day the portfolio is put into being. On the following day, the actual proportionate mix will be different. And the next day it will be different again. Welcome to the world of portfolio drift.

Typical structure

For a moderate risk investor (EValue profile 3) seeking a balanced long term portfolio, a typical asset/sector structure might look something like this...

Asset Class Weighting  Sector  Weighting 
 Property 5.00%     
     N/a  5.00%
 Fixed interest  32.00%    
     Government bonds  17.00%
     Corporate bonds  15.00%
 Equities  63.00%    
     UK  29.00%
     US  22.10%
     Europe  6.8%
     Japan  5.1%
 TOTAL 100.00%     100.00%

The changes on any single day – even on a volatile one – will normally be minimal, but over time they will accumulate. Thus the initial miniscule gap between the model portfolio and the reality could become a wide one.

The changes are driven by relative performance – it is not simply a question of funds making gains and others recording a losses. To see the effect over time on a very simple portfolio, take a look at this example...

The drift

Consider a very simple portfolio, set up as 60% UK equities and 40% government bonds on the last day of 2008. The performance of both asset classes matches that measured by Barclays Equity Gilt Study 2019, assuming all gross income is reinvested.

The graph below shows the true allocation at the end of each year through to the end of 2018 assuming no portfolio changes were made. The greatest extent of the drift occurred at the end of 2013, when the equity allocation had grown to 69.26% and the bond allocation had correspondingly shrunk to 30.74%.

Portfolio2

The obvious solution to this drift is to rebalance a portfolio regularly, bringing the asset allocation back into line with the original target (assuming that structure remains valid).

For instance, in the example above, after 12 months (the end of 2009), the allocation had become 66.15% equity and 33.85% gilt because the equities had returned 29% over the year while the gilt return was -1.0%.

To rebalance it would have been necessary to sell almost a tenth of the equity holding and reinvest the proceeds into gilts. The rebalancing process forces the sale of part of a better performing asset and purchase of a lesser performing one. In that respect it represents a variant on the familiar advice to “buy low and sell high”.

Example 3 shows how the rebalancing process would have operated over the last ten years to bring the portfolio back to the 60/40 initial balance at the end of each year. In contrast to 2009, in 2015 hardly any change was necessary as there was only a 0.6% difference in returns between equities and gilts.

Automatic rebalancing

Theoretically rebalancing can be undertaken manually, diarising the task and then selling and buying funds for each client’s portfolio. That can be a strain and a risk – the ‘fat finger’ syndrome must not be forgotten. It may also require client consent to carry out the transactions, if the adviser does not have discretionary powers.

A more practical approach is to opt for automatic rebalancing, provided the platform used offers this facility. Automation can dramatically simplify the process while removing the risk. It also allows advisers without discretionary powers to undertake rebalancing, provided that the automatic procedure is incorporated into the initial client agreement.

Rebalancing example 3

Rebalancing in action

While leaving the computer to do the rebalancing looks like a no-brainer, there are a number of factors that need to be considered:

How automatic is automatic? Is the automatic process one size fits all? For the same client, you may want to have different portfolio profiles and possibly different rebalancing timings/frequencies for different wrappers (e.g. pensions in drawdown and direct investments). Can the platform cope with this easily – or at all?

Transaction costs: Buying and selling funds could incur transaction costs, something which varies between platforms. Any costs need to be considered – too high a cost could nullify the case for rebalancing or at least reduce the frequency of the exercise.

Does the platform offer pre-funding? In some respects, rebalancing is another form of switching. Some platforms make rebalancing, like a switch, a two-stage transaction: the purchase of the balanced-up funds is not made until the proceeds of the sale of the balanced-down funds have been received. That can be a four day out-the-market gap - a timeframe which could make a difference in volatile markets – and should be conveyed to clients.

To avoid this risk, it is worth considering a platform that ‘pre-funds’ rebalancing, i.e. one that will execute the purchase in advance of receiving the sale proceeds.

Capital gains tax: Any rebalancing sale will potentially have tax consequences, whether it be the realisation of a gain or a loss. In many cases the sums involved will be relatively small because only a fraction of a holding is being disposed of.

The annual exemption (£12,000 of gain in 2019/20) will usually mean there is no capital gains tax (CGT) bill and nothing to report to HMRC. HMRC take the view that the ‘small disposals rule’ does not apply in such circumstances. If the client realises other gains – perhaps the sale of a buy-to-let property – then there could be CGT to pay on rebalancing. In those circumstances it might be better to delay any rebalancing until the following tax year.

One arcane point to watch is that if total sale proceeds in a tax year exceed four times the annual exemption, these will need to be reported – with details of each transaction – even if the gain is under the annual exemption. That makes clear platform reporting of transactions and related gains important, if not for the client, then for their accountant.

Frequency: The frequency with which rebalancing should take place depends on a mix of the factors considered above and the overall effectiveness.

Rebalance quarterly and the net result starts to look a little like a hamster on a wheel, generating multiple small transactions that make little difference. The commonest frequency chosen is annually or every six months. Any longer means that an annual exemption may go unused and potentially increases the eventual gain crystallised by rebalancing.

Peace of mind

Re-balancing is not about chasing performance, but simply maintaining the asset allocation which matches the client’s risk profile and which they signed up to.

The impact of volatility is one reason for rebalancing, but that does mean that a period of volatility should prompt ad-hoc rebalancing. To do so is akin to trying to time the market, with all the dangers that brings.

Rebalancing should be a process that is unaffected by market ‘noise’, something best achieved by keeping to a pre-determined frequency. It is there to ‘recondition’ your client’s portfolio and give them the knowledge that their portfolio will continue to be aligned with those investment goals and risk tolerance agreed at outset.

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