Everything You Should Know About Portfolio Rebalancing

If you have financial goals and have a financial plan to achieve these goals, you would have surely heard of portfolio rebalancing. Most of us understand what is portfolio creation. After all, you select equity funds and debt funds according to your long term goals and then the mix will gradually grow to help you achieve your goals. But then investment plans are never static and that is why rebalancing becomes important.

Portfolio rebalancing is all about restoring the right asset allocation. Let us take an example. Your allocation is 70% to equity and 30% to debt. We will not get into other details. Now there is a bull rally for 2 years in succession and during this period you find that the Net Asset Value (NAVs) of your equity funds have gone up sharply. So what exactly happens.

That is where rebalancing based on cut-off markets come in handy. Normally, when you create an asset allocation plan, you keep a 10% leeway. For example, the last 2 years of bull market may have taken your equity component in the mix from 70% to 84%. Now that is a serious divergence from your allocation and needs rebalancing.

Here rebalancing will mean you shift out of equities and get into debt so that the 70:30 allocation is restored. This has two advantages. At no point, the asset allocation is too much off your original target. Secondly, when you book profits at higher levels, you automatically take profits out in a systematic manner and keep liquidity when markets correct. That is the essence of portfolio rebalancing and the idea is to restore asset allocation.

There could be a number of triggers for you to rebalance the equity component.

• Firstly, you may have taken a small exposure to sector funds or thematic funds and the cycle may be peaking out, so you must move to more diversified funds.

• The funds of the AMC you bought may be consistently underperforming the market and the peer group. Consistent underperformance calls for rebalancing out.

• Each of your investments is normally linked to a goal. Once the goal is achieved, it makes sense for you to rebalance back to the original asset allocation.

• Global macros may be changing so if interest rates are rising then it is a time to move out of banking funds and if dollar is weakening it is time to move out of IT Funds.

• Diversified funds may not be doing any better than index funds, in which case you can rebalance more in favour of low-cost index funds or ETFs than active funds.

• There are times when debt funds may be less attractive than FDs in post-tax return terms. You can as well shift to the safety of fixed deposits.

• If financial stress is seen due to the pandemic or rising interest rates, you must rebalance in favour of more of AAA rated bond funds and G-Sec funds.

• A key trigger for debt fund rebalancing is interest rate trajectory. For instance, prefer longer duration debt when interest rates are on the way down and perhaps shorter term funds or floaters when rates are going up.

• Is there a trigger to shift out of debt into equity. Look at the earnings yield of equity (inverse of P/E ratio) against yield on debt funds. If the gap is too high, it is either time to underplay equities or overplay equities, as the situation demands.

• First and foremost look at the cost of rebalancing the portfolio. Any rebalancing has a cost in terms of brokerage and commissions, cost in terms of statutory charges and costs in terms of exit loads. It also has costs in terms of opportunities lost.

• Is the rebalancing really going to be worth it. Every year, you review the portfolio, but does not mean you have to rebalance the portfolio. That is warranted only if the benefits outweigh the costs. In short, Rebalancing is a major decision so the conviction has to be there that the shift will be actually value accretive.

• Don’t forget the all-important tax consideration to be taken into account before rebalancing. Equity and debt have different criteria for calculation of capital gains tax. It should not happen that you give away your tangible benefits so look at every decision in post-tax terms only.