A Careful Balancing Act

I am very grateful to an old friend, Jonathan Davis, for an excellent column in last week’s FTfm in which he addressed the issue of portfolio rebalancing. This might sound a somewhat tiresome and technical subject but it is actually one of the fundamental elements of effective and disciplined portfolio management. In his article (which might well be better reading than mine) he quotes the well regarded US fund management group Vanguard who have various research papers on this subject.

The key point about portfolio rebalancing is to ensure that the spread and percentage of asset classes in a portfolio are kept within a given proportion - and why is that important? The answer comes down to the level of risk that investors are willing to accept. In Vanguard’s research paper they cite data from 1926 to the present covering the US equity and bond markets. What their figures illustrate is that if you had a portfolio with a split of 60/40 with just equities and bonds, then if there was no rebalancing discipline during that time there would have been an equity creep (that is also an unofficial term for certain stockbrokers I know) such that you would have ended up with 97% in equities. This ‘equity creep’ occurs as equities should rise in value over time. As a result this would now have become a very high risk portfolio - for a client who probably would have signed up for something a lot less risky.

Thus by having a discipline of controlling the pressure of rising equities, the risk levels can be maintained and controlled. This then gives rise to the subsequent questions of how often to rebalance and at what trigger of percentage variation would be appropriate.
What this in effect means is that irrespective of external pressures, investment managers will be forced to sell out of certain asset classes and buy others despite their own personal views or prejudices. This could be both good and bad news, so for example when equity markets get into a slump and your percentage drops, then portfolio rebalancing would force you to buy ‘cheaper’ shares - buying when others are scared! Equally of course if you are too rigid in rebalancing you could be forced to sell the asset class you like and be forced to buy the asset class you hate!

So what to do? Well some do nothing at all - in which case you are left with that tiresome equity creep again. Or alternatively...

Some rebalance to exact percentages at given times of the year. So if you are up at the Summer solstice you will not be alone as there are both druids and asset managers casting runes and buying and selling because it is a given date in the year. Strange but true, as some investment houses and programmes operate quarterly or half yearly rebalancing investment regimes.

The effective answer is as ever somewhere in between. A most effective structure would be to ensure that there is still a rebalancing process but to allow the percentage of various asset classes to move within a given range and only then will you need to act if they breach the extreme bands on either side. This gets away from the dogma of rebalancing with druids according to a given date (and the extra costs as well), whilst still ensuring that the equity creeps are effectively contained.

Does it work? Well the answer has to be yes - and that is what we at 7IM have done so far with some success. Investment rebalancing is a necessary discipline if carried out in pragmatic manner - but it is certainly not a blind dogma.

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A date to pencil in - Wednesday 20th October at 12.30pm. This is when we will finally get to see the results of the Government’s Comprehensive Spending Review. This is going to be crucial in order to see how the Treasury team of Boy George and the red headed ‘Beaker’ are going to shape the country’s finances over the next four years. Obviously it seems that their plan to date is to get all the bad news out as quickly as possible, and then to threaten fire and brimstone in the hope that by the time the election comes around (assuming the coalition holds) there will have been either enough growth and/or enough inflation to have reduced the structural deficit to such a level that they can show that they don’t need to do all the cuts after all. Bravo and then all you have to do is get re-elected!

Good plan so long as there is some growth somewhere for someone to buy our exports and that we are not beset by an extended bout of deflation. Inflation we British know all about and how to (painfully) address it - but deflation - that’s more of a problem. It’s taken the Japanese twenty years not to fix it.

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And finally... News from Illinois. Police said a 30-year-old woman apparently fell out of a
third-story window, landed on her parked car, and then walked into a neighbour’s house, where she fell asleep on a couch for two hours. A spokesman said the woman bounced off the hood of her car, walked through a neighbour’s open garage door and went into the house.

The neighbour found her asleep two hours later and called 911. The woman, whom police have not identified, was taken by ambulance to hospital where she was not suffering from any life-threatening injuries.

Now just try explaining that on your car insurance claim.

PS - A word on the football  the England rugby team won the World Cup under the guidance of the talented Clive Woodward having undergone a root and branch development plan looking right through the entire process from mental attitude to individual personal as well as team behaviour. Additionally the British Olympic cycle team which swept the board at the Beijing Olympics won as a result of a similar in-depth planning and restructuring plan covering even more detail from equipment and clothes design, to mental strength and team appreciation.

Something to learn here?

Have a good week.

Justin A. Urquhart Stewart
Director
Seven Investment Management Limited

For previous editions of our Weekly Update, please click here

This article represents a personal and light-hearted view from Director, Justin Urquhart Stewart of Seven Investment Management Limited, and is based on current financial news and events around the world. Its content should not be used for investment purposes and you should contact an independent financial adviser before making any investment or financial decision. Seven Investment Management Limited is authorised and regulated by the Financial Services Authority. Member of the London Stock Exchange. Head office: 23 Austin Friars, London EC2N 2QP. Telephone 020 7760 8777. Registered in England and Wales number 4092911. Registered office: 3 More London Riverside, London SE1 2AQ.