Why do we rebalance our portfolios?

Finax has brought automated regular rebalancing as one of several novelties to the Slovak market. What does this foreign word mean and what benefits does it offer for your investment?

Radoslav Kasík | Our process | 29. March 2018

• What is rebalancing? 

• Rebalancing maintains the portfolio's risk at an appropriate level.

• Rebalancing steadily increases the return on investment. 

• When and how do we rebalance? 

• How can maintenance of the portfolio structure increase revenue?

What is rebalancing?

Rebalancing, unlike its title, is not complicated and it is very beneficial for your investment.

As the name itself suggests, it is about maintaining balance, that is, equilibrium. Finax is engaged in intelligent investing, so we are tracking the balance of client investment. 

Simply put, rebalancing means keeping the portfolio’s structure at the originally chosen composition, optimal for investor's goals and his/her risk profile.

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When opening a Finax account, our algorithm selects a portfolio tailored for the client. Finax's investments are made up of 10 ETF funds targeting different classes of assets, for instance, shares of large US companies, small European companies and world government bonds. Individual client accounts differ in the structure of funds based on the selected portfolio risk.

However, the composition of the portfolio changes over time. The different classes of assets never develop equally. Some grow faster than others, or some grow when others fall.

Stock prices, for example, change more than bond prices - they have higher volatility, but historically achieve higher returns. Developing countries' or smaller companies' shares experience bigger price movements than those of big companies in mature markets.

Different fund developments also change their weight in the portfolio, as shown in the following graph comparing the composition of the Finax 50/50 strategy in November 2013 (50% of shares and 50%of bonds) and 2 years later in November 2015 (56% of shares and 44 % of bonds).

Rebalancing means setting the composition of the investment to the initial or optimal level - the original composition that was selected for the client at the beginning of the investment according to his/her objectives, options and attitude towards risk.

Rebalancing is done through a simple sale of funds whose current portfolio weight is greater than the original weight at the beginning of the investment, and by buying underrepresented funds whose weight in the portfolio is lower than it is supposed to be according to the optimal composition.

Why do we do rebalancing?

The quality of each investment is measured by its yield and the associated risk. The basic investment relation is that higher yield always brings higher risk and vice versa.

The portfolio manager's goal is to achieve the highest possible return while maintaining the lowest acceptable risk for the investor. Increasing yields while reducing risk is then the dream of each investment manager. It is the holy grail of investing.

The prime role of rebalancing in managing the Finax portfolio is to maintain the investment's risk at the chosen acceptable level. 

Mixed portfolios composed of different classes of assets tend to increase their risk over time. Long-term stocks and other risky assets are growing faster than safer assets. As a result, their share in the portfolio increases and the investment becomes riskier.

If, for example, the algorithm selects a balanced portfolio of 50% equity funds and 50% bond as a suitable investment for the client, the stock weight will be 70% in few years and the bond weight will be 30%. However, this is already a significantly different growth portfolio with a higher risk.

Note: All data relating to the historical development of the Finax portfolios is modelled and based on data back modelling. We described how to model historical performance in How we model historical portfolio development. Past results are not a guarantee of future returns and your investment may result in a loss.

However, when the markets are in decline, this relation turns the other way around. Portfolios become more conservative at that time – proportion of safer assets grows. Their potential for profitability is falling, thereby the investor can lose a part of the profits in the next period. Therefore, it is always advisable to have a properly set portfolio composition. 

Our goal is to maintain a stable portfolio risk at a level with which the investor feels comfortable. In addition, it is required by law to act in this way in the case of managed portfolios, such as Finax Intelligent Investing.

How do we rebalance and what are the other benefits?

We at Finax were not satisfied with the general portfolio rebalancing. We wanted to know when and under what conditions is it best for our clients to return the investment composition to the optimal level.

Through detailed analysis and long-term testing of dozens and dozens of portfolio balancing methods, we have developed our own rebalancing system.

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The result of our know-how is a rebalancing system that increases portfolios´ profitability and reduces their risk. 

On a 30-year horizon, rebalancing increased the performance of dynamic, growth and balanced portfolios by an average of 0.41% per year. This effect is smaller for strategies with a larger share of bonds.

The benefits of rebalancing are more substantial at turbulent times and by bigger price movements in the markets. Therefore, rebalancing has increased the yield of strategies with a larger share weight by 0.65% on average per year over the past 20 years.

The result of our rebalancing research is an interval for the weight of each fund in a portfolio. Once a fund's share in a portfolio crosses the boundaries of the interval, rebalancing begins, and the portfolio composition returns to the optimal state.

Finax Rebalancing is automated. Our system monitors the composition of all clients' portfolios and if the portfolio structure changes significantly, it is rebalanced. 

It cannot be determined in advance, when rebalancing will be carried out. We do not have any fixed dates for portfolio adjustments.

Rebalancing is always non-taxable. One of the basic principles of Finax is zero tax, which has priority over rebalancing. Thus, rebalancing can be postponed for several months if it would result into tax liability. 

Finax carries out rebalancing without charging transaction charges or any other fees.   

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Why does rebalancing increase returns?

Our clients often ask how can rebalancing provide such considerable benefits, such as an increase in yield of up to 0,65% p.a.. Even we were pleasantly surprised by the testing, so we studied the causes more in depth.          

In the first place, rebalancing automatically provides another holy grail of investment - it sells when the prices are high (expensively) and buys when they are low (cheaply). It is an investment art that looks simple on paper, but in reality, it is done by only a few.

Rebalancing does what every investor should do, but often fails at because of psychological temptations. Simply put, the investor takes profits from investment. 

The weight of the sold ETF funds is relatively higher than the initial composition, which means that their value grew faster than the value of underrepresented funds. The relative performance of the purchased assets is worse; therefore, they are cheaper compared to the assets sold.

Declines of the non-rebalanced investments are more significant and increases lower than the rebalanced portfolio.

If equity markets drop by 20% and you have 60% of stocks in your portfolio instead of 50%, the portfolio will depreciate by 12%, but only by 10% if the investment structure is set correctly. With 100% stock market growth, if stocks make up only 30% of your portfolio, the investment will increase by 30%, while in the optimal case of 50% equity portfolio composition, the investment increases by 50%.

  

Rebalancing is a great instrument for passive investing, which is the best way to make your savings grow. It takes measures that should be part of each investment strategy, but investors themselves tend to neglect them for various reasons - it maintains the risk of investment at the chosen level, sells expensive assets and buys cheap ones, increasing the return on investment and minimizing its risk. 

Rebalancing is a huge asset and added value to Finax Intelligent Portfolios that is unmatched in its form by any investment product in Slovakia.

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