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Determining how to spread your funds across investment asset classes of varying risk and potential return is one of your most important investment decisions.
Having a lot invested in equities will likely mean your long-run returns will be higher, but also that you will have to endure more volatility along the way. By contrast, allocating a large proportion of your funds to relatively less volatile cash or bonds may mean you sacrifice returns in exchange for greater capital stability.
The aim is to have an asset allocation that gets the balance between high and low-risk assets right for you – both now and over time.
The Need for Portfolio Rebalancing
Asset allocation is not a ‘set and forget’ decision. Your exposure changes as markets move. A strong run in equities will mean the share of your portfolio invested in ‘high-risk’ assets (shares) will increase, making your portfolio more volatile. This may be inconsistent with your desired risk/return profile.
The aim of rebalancing is to adjust your exposure to maintain your target asset allocation.
Rebalancing may also be required as your risk profile itself changes. For example, it’s generally recognised that as an investor ages, capital preservation, income stability and risk management become relatively more important than they were in the investor’s youth. As you approach retirement, you might seek to de-risk by decreasing your exposure to equities, and increasing exposure to cash or bonds.
How often should I rebalance?
In the case of broad asset classes, there is often a ‘regression to the mean’ – periods of strong returns are often followed by periods of weak returns. For this reason alone it can be prudent to trim exposure to asset classes that have run strongly for a period of time.
Research suggests that monthly or quarterly rebalancing is probably too frequent, and can also involve excessive trading costs. It also is at odds with the fact that momentum within asset classes is often positive over periods up to 12 months.
By contrast, waiting several years is probably too long due to the regression to the mean principle.
A reasonable compromise may be to rebalance around every 12 months. This also may offer tax advantages to eligible investors, as assets held for more than 12 months could be eligible for the capital gains discount when sold.
What should I buy?
Exchange traded funds (ETFs) can be an efficient way to achieve rebalancing, as they offer broad diversification in one trade, at relatively low cost. This avoids the need to select individual stocks or bonds, and the consequent risk that you get the asset class ‘right’, but choose the ‘wrong’ investments within the asset class, resulting in underperformance.
For example, if you are looking for increased exposure to the Australian sharemarket, our A200 fund gives you broad exposure to the Australian market for an annual management cost of only 0.07% (the lowest-cost broad Australian equity ETF in the world).
ETFs allow you to adjust exposure to international equities, or to sectors of the market, for example the Financials or Resources sector. A particularly popular sector recently has been technology, and we have seen strong interest by investors in NDQ, our NASDAQ 100 ETF.
ETFs also make it straightforward to increase your allocation to more defensive assets such as corporate or government bonds, assets that are hard for individual investors to access directly.
Our CRED ETF, for example, aims to generate income higher than that paid on cash, term deposits, or government bonds. Its returns have also tended to be negatively correlated with equities, helping with portfolio diversification.
Another asset class that has been popular in exchange-traded form is hybrids. Using our Active ETF HBRD, investors are able to gain access to a diversified portfolio of hybrid securities. With the threat to the refundability of surplus franking credits now removed following the election, this fund may be attractive to investors looking to rebalance in favour of income-generating assets.
Note: The above information is general in nature and is not personal financial advice.