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FundsIndia Explains: Rebalancing a Mutual Fund Portfolio

February 12, 2018 . Mutual Fund Research Desk

When you start to invest, you build a diversified, asset-allocated portfolio. This allocation is based on your goal timeline, your risk appetite, and other factors. That is, based on what you’re aiming for, this is the equity-debt proportion that works best for you.

As markets move, your asset allocation proportion changes. Your equity allocation could go up if markets rally for a long time, or it could go down when markets correct. So you need to rebalance it to bring it back in line with the original. But what is rebalancing and what does it entail? Read on to find out.

What is Portfolio rebalancing?

Portfolio rebalancing is the process of bringing a portfolio back to its original asset allocation. In an asset allocated portfolio, the target proportion of debt and equity is determined based on your time frame and risk profile. Over time, if one asset class moves more than another, the allocation between them may diverge from the original. The skewed allocation will affect the portfolio’s returns and the risk you are taking.

Take this example for instance. Over the past couple of years, equity has seen an unprecedented rally, whereas long term debt has underperformed over the last year. In such a scenario, the equity component of a portfolio will grow more than debt. This will lead to your portfolio having more equity by value than originally intended. In such a case, you would need to reduce your equity exposure to restore the original allocation.

Why do you need to rebalance?

There are two main reasons why you should rebalance your portfolio. First, is to keep the risk you are taking within sustainable limits. Based on your inputs, say you had a portfolio made up of 60% equity and 40% debt. This proportion is ideal within the limits set by your risk appetite and your timeframe. However, if the equity component goes up to 65%, then you are taking more risk than you originally intended and what was prudent given your timeframe. Hence restoring the original allocation will keep the risk within your tolerance limit.

Second is to take advantage of a rising asset class and investing in a cheaper valued one. This also helps avoid having to time the market. If the equity component of your portfolio has grown more sharply compared to debt, it is usually because stock markets have gained handsomely. When you rebalance, you would actually be booking profits in the asset class that has rallied (equity) and getting into the relatively undervalued one (debt). Rebalancing when equity-debt gets out of sync is better than trying to redeem based on market conditions. In trying to time markets,you may end up redeeming before you have sufficient gains, whether in debt or in equity. Instead, if you focus on your own portfolio and rebalance when called for, it will ensure you book your profits in a timely manner.

When should you rebalance?

The easiest and most practical way to rebalance is by reviewing your asset-allocation on a yearly basis. As soon as the asset allocation diverges by a certain percentage, you can rebalance it at that point.

The normally recommended divergence is 5%. So if your target equity allocation was 60% and the current allocation is 55% or 65%, you should rebalance your portfolio. This is only a recommended threshold and you are free to determine your own limits. 5% is a level which does not lead to frequent rebalancing and yet ensures that in times of sustained rally or underperformance, you take corrective action on time.

How should you rebalance?

This is perhaps the most important question of all. There are three ways to rebalance your portfolio:

  1. Redemption: In this method, you redeem from the asset class which has grown more, thereby bringing down its value. Suppose you invested Rs. 60,000 in equity and Rs. 40,000 in debt. Over the years, equity grew to Rs. 1,50,000 while debt grew to Rs. 80,000. The allocation has been skewed to 65:35. To restore the original allocation, you can redeem Rs. 30,000 from the equity component.
    However, this method is not recommended, as it reduces the value of the entire portfolio, making it difficult to reach your goal. It also brings up the question of deploying the redeemed amount – when would you invest it back into equity? It would amount to timing entry and exit, exactly what you want to avoid. Besides, if you keep that money in your bank account, it would be earning sub-optimal returns.
  2. Fresh investment: In this method, you bring in fresh money to the asset class which has lagged behind. This increases the value of this asset class and restores its original allocation. Taking the above example, you can invest Rs. 20,000 in debt to restore the original allocation.
    This method may pose practical difficulties at the time of execution depending on the amount which needs to be brought in. As the years go by, your portfolio value would also be rising and therefore, amounts needed to be brought in may consequently be high. However, if you have investible surplus, this method is recommended as it is the easiest.
  3. Switch: In this method, you switch from the asset class where the allocation has gone up disproportionately into the asset class where the allocation is lagging behind. Once again, carrying forward the above example, to restore the original allocation, you can switch Rs. 12,000 from your equity fund to your debt fund. You will end up with Rs. 1,38,000 in equity and Rs. 92,000 in debt, which is in the proportion of 60:40. This may be slightly trickier to execute and may involve tax incidences, but it would help where bringing in fresh money as explained in the previous point is nonviable.

Where should I redeem from and invest into?

Each of the approaches listed above involves either redemption or investment or both. In an asset allocated portfolio, you will have several funds. How do you decide where to redeem from and where to invest the money? There are no hard and fast rules for this. However, you can take the following points into account while making your decision.

If you need to redeem:

  • Choose a fund which has been consistently underperforming.
  • Prioritise funds where you do not have running SIPs and redeem from those. For instance, if you had invested in a fund initially, where you stopped the SIP later to invest in a better fund, you should redeem from that fund first. It can also be easier to account for exit loads and holding periods for funds where SIPs have stopped.
  • Use category allocation within an asset class as a guideline. For instance, if your midcap funds have run up a lot more than large cap funds and your mid-cap allocation is much higher than what you started out with, prioritise redemptions from midcap funds. This will also help you restore the original category-wise allocation within that asset class.

If you need to invest:

  • This is easier – simply choose the funds which are consistently doing well. You do not need to add new funds every time you rebalance.
  • If you have funds where you have running SIPs, consider further investments in these rather than the ones where you have stopped SIPs due to underperformance.
  • Again, go by category allocation. If there is a category where the allocation is lower than your original portfolio – say income funds in long-term debt, add fresh money here to bring it back in line.

When you’re bringing in money to any fund, ensure that  the underperformance was because of market factors rather than the fund’s own underperformance.

Of course, rebalancing is possible only if you have a properly built asset-allocated and category-allocated portfolio to begin with. For any goal, a balanced portfolio is always the best way to match risk, time-frame, and returns. It ensures that you don’t go overboard on any asset class or stay under-invested in one. If you haven’t got an asset-allocated portfolio yet, review your portfolio to bring it in.

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