Day: 4 May 2020

By Carol Lye. Regional Portfolio Manager – Brandywine Global

Slowing growth, de-globalization, and higher savings rates may warrant greater caution and selectivity with respect to emerging markets debt over the next decade.

A black swan virus shock has brought the world to its knees—dealing a particularly acute blow to emerging markets. It was only a year ago that developing markets had emerged from the previous Federal Reserve (Fed) tightening and trade war crises. Britney Spears’s “…Baby One More Time” seems like an apt description for the series of shocks that emerging markets have gone through. However, this time around both developed and emerging markets have experienced large currency depreciations as seen in volatilities. Yet this might morph into more of an emerging market stress than previously imagined. As we sit here sifting through the effects of COVID-19, we reflect on some of the stresses emerging markets may face and assess the road ahead.

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Some investors use a set-it-and-forget-it approach to their portfolios, but there are times when the asset mix may need to be recalibrated to achieve one’s goals. Here, Franklin Templeton Multi-Asset Solutions’ Gene Podkaminer and Wylie Tollette discuss the importance of rebalancing one’s portfolio, especially during times of market turmoil, and how different types of investors can accomplish the task.

How to Think about Truing up Asset Allocations in Times of Market Stress

During normal times, rebalancing a portfolio is a relatively mundane exercise, an activity that can be performed succinctly and often mechanically. But when markets gyrate, as they have recently, an investor’s approach to rebalancing becomes much more complex. And unlike many other aspects of investing, rebalancing is somewhat of a dark art with few universally accepted rules. Ultimately, rebalancing is the feedback loop between your actual portfolio and the carefully crafted asset-allocation ranges you devised in calmer times

Over the past several months, we have observed price declines in many assets considered riskier (such as the many flavours of equity), coupled with mixed performance or even appreciation in assets considered less risky, such as bonds.

What is an investor to do when their thoughtfully constructed asset allocation comes in contact with the financial aftermath of COVID-19? Allow it to drift? Micro-manage the investments to precisely match target ranges? Perhaps a bit of both?

We’ve observed asset allocators adopt a wide range of responses to these questions, with some allowing portfolios to drift hands-off while others aggressively true up to ranges. Many institutional and professional investors formally document their portfolio weights, while individuals may take a less formal approach. But that doesn’t change the calibration of a mix of assets to a certain risk tolerance, whether expressed explicitly as the Greek letter λ (lambda) in an optimiser, or implicitly as a static proportion of stocks vs. bonds for those less versed in Greek. So, allowing a portfolio’s allocation to unintentionally drift implies that the risk level has also drifted away from the target.

A Reminder: Why Should You Rebalance?

Let’s take a step back to recall the central idea underlying rebalancing. Rebalancing enables an investor to maintain a consistent mix between more risky and less risky assets through changing market conditions. A disciplined rebalancing process should mathematically translate to a more stable risk journey over time, instead of one which mirrors the ups and downs of equity markets (We’re picking on equities because they tend to be the riskiest investment in most portfolios).

Ignoring rebalancing entirely means that the important diversification choices you likely have built into your portfolio are effectively undone. Rebalancing is, by design, contrarian. And we’ve learned from behavioural finance that such counter-cyclical behaviour will likely lead to some degree of discomfort in the moment.

Exhibit 1 below graphs two illustrative approaches: Portfolio A is rebalanced monthly, and Portfolio B is never rebalanced. The top two lines graph the cumulative wealth of both portfolios, with each starting at US$100 10 years ago (on 1 March 2010). We look at annualised standard deviation as a proxy for risk and observe similar results: Portfolio A has experienced less risk over the past 10 years vs. Portfolio B. Combined, both of these attributes lead to Portfolio A retaining more of its wealth because of the smoother ride resulting from lower standard deviation, it experienced less of the “volatility penalty”.

The table in Exhibit 2 helps us quantify the graph further. In Portfolio B, the equity allocation swings around from 56.1% to 73.5%, which contrasts with the steady 60% allocation for Portfolio A. The volatility rises from 7.3% to 8.6% without rebalancing, and that impacts the overall return, which falls from 5.7% to 5.0%. Note that we ran similar analyses over the past 20 and 30 years, also using quarterly as well as monthly rebalancing, and arrive at similar conclusions.

Exhibit 1: Rebalancing Vs. No Rebalancing 60/40 Portfolio: Monthly 

Exhibit 2: Comparison of Rebalancing Vs. Not Rebalancing

But, of course, it’s never quite that easy. Rebalancing involves transacting in the market, which means buying and selling—and all of the costs and frictions associated with those activities, including commissions and taxes. Which leads us to ask: what is a balanced approach to rebalancing?

The Range of Rebalancing Options—and Considerations

We ask several questions of rebalancing: when should we rebalance, should we rebalance to an outer range or all the way back to a target weight, and when should we let rebalancing slide? To answer these questions, and more, let’s discuss three common approaches:

1. Calendar-based rebalancing: the simplest method, this could be quarterly, but some use monthly or annual cycles. (We use this approach in Exhibits 1 and 2.)
2. Range-based rebalancing: when a given investment is outside some prespecified range, action is recommended. Many institutional investors with formal investment policy statements use this approach.
3. Risk-based rebalancing: shifting the mix of assets when striving to keep the overall portfolio risk level close to a prespecified target. If equities are expected to contribute more risk to the overall portfolio going forward, then their weight would be proportionally reduced to maintain the desired overall risk level.

We mentioned transaction costs, taxes, and other frictions earlier, but there are also several other factors to consider before rebalancing, including:

• How willing are you to let momentum ride, that is, for recent strong performers to continue instead of trimming them back?

For instance, if your investments are taxable, then a potential rebalancing move could be weighed against the explicit tax cost, in addition to any execution cost. If you believe in momentum, then you may justify wider allowable ranges. However, if you think mean reversion (where assets return to their long-run average valuation over time) is prevalent, that may encourage a slower rebalancing cadence, with more patience involved as you wait for prices to adjust closer to historical averages. Your approach to rebalancing says a lot about how you view the future, whether you believe in momentum or reversion back to the mean.

If you’re utilising a range-based approach, how far back into the range do you go? Let’s assume that you have a 60% global equity, 40% global fixed income portfolio with a ±5% range around each. If your portfolio currently reads 50% equity, 50% fixed income, do you rebalance back to targets (60%/40%) or to the edge of the range (55%/45%)? We’ve observed that many do the latter (to the edge) because the cost and disruption of transacting can be high.

Also, investors may have the opportunity to “virtually” rebalance using new funds to top up underweight asset classes, or conversely to fund necessary withdrawals from overweight asset classes. Unless the portfolio composition is substantially distorted, phasing back to target weights may be an equally effective, if lighter-touch approach.

The concept of using new funds or contributions to, or withdrawals from, the portfolio to align weights can be used in situations where regular cash flows occur (regardless of direction), such as pension funds, individual retirement accounts and college savings programmes. Topping-up underweight asset classes or pulling funds from overweight asset classes provides for dollar-cost-averaging vs. a one-time “big-bang” rebalance, thus maintaining a contrarian mindset, which can be helpful in times of market turmoil.

What Do Others Do?

Many may be wondering how sophisticated institutional investors approach rebalancing challenges. Some use so-called “overlay” programmes where a small dedicated cash sleeve is invested in equity and fixed income derivatives, creating levered synthetic positions which can then be quickly and seamlessly changed to ensure the overall portfolio exposures stay in balance. But an overlay program only has so much reach; at some point rebalancing among the portfolio components is necessary, and the overlay proportions reset.

Some institutions carefully manage new fund flows to stay within acceptable ranges, though at some point selling relatively better-performing assets is still required. For those institutions which use a factor-based asset allocation approach, the risk-based rebalancing approach is a good fit because they approach investing from a risk-first posture.

Contemplating a rebalancing discipline is as much about reducing risk as eking out some marginal return. Our focus has been on examining rebalancing through a risk management lens as investors can attempt to control risks, while forward-looking returns are unknown. For many investors, the prospect of a smoother ride is a compelling reason to consider adjusting a drifting portfolio back into spec. These are not simple questions, and each investor has a unique approach to rebalancing, whether quarterly to the edge of the range or a one-time shift back to target.

Rebalancing shouldn’t be thought of as a stand-alone discipline; instead, it is just one part of a comprehensive approach to asset allocation and risk management.

 

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What are the risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Diversification does not guarantee profits or eliminate the risk of investment losses. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets.

MeDirect Disclaimers:

This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.