Watch the costs when it comes to rebalancing

Earlier in this series of articles on Portfolio Management we looked at why equally weighting all the positions in a portfolio is a sensible approach for many investors. The trouble of course is that over time, even if you do nothing with that portfolio, those weights will get out of whack. As some shares soar and others stumble, position sizes change and that can leave you over-exposed to a smaller number of stocks. Rebalancing the portfolio can fix this issue but it’s important to remember that too much tinkering can incur costs that could damage returns.

What is rebalancing?

Rebalancing means tweaking your portfolio so that it’s weighted and diversified according to the original plan. That can mean taking the counter intuitive decision to trim positions in stocks that are doing well. In doing so, you deploy cash to stocks that are doing less well (or cut loose the laggards and introduce new stocks to the portfolio). The philosophy behind rebalancing is mean reversion. What that means is that markets and stocks tend to move in cycles, and a poorly performing asset won't always do badly and a high-flyer may eventually come back down to earth.

Both buy-and-hold investors and stock picking ‘hunters’ are sometimes wary of rebalancing because it contradicts advice that you should cut your losers and run your winners. The short answer is that unless you’re an above average stock-picker who can control the emotions of fear and greed and expertly time the sale of investments, some form of rebalancing may well help to manage risk.

Morningstar founder Pat Dorsey illustrates the perils of not rebalancing in The Little Book That Builds Wealth. In it, he tells the story of a stock he bought in the mid-1990s called EMC Corporation. He watched the price go from $5 to $100 in three years - and right back to $5 a year later, along with the majority of his return. He said: “I had made a great purchase decision but my overall return on the investment would have been far, far greater had I been smarter about selling.”

Many market professionals and guru investors endorse the idea of rebalancing. A common suggestion - from the likes of fund manager Joel Greenblatt and financial theorist Robert Haugen - is to ‘churn’ a portfolio no more than annually. Others suggest half-yearly, quarterly or even monthly. Deciding on the best rebalancing strategy is entirely personal and dependent on several key factors as follows:

Rebalancing factor 1: Size

Size matters. The greater the value of your portfolio the lower the relative cost of trading those shares will be. As a result, the size of your portfolio in value terms can be a big influence on the cost-effectiveness of regular rebalancing. Share purchases incur broker commissions (of around £10 per trade) and stamp duty of 0.5% (unless it’s an AIM stock). Commissions will also be levied on sales, too. Don’t forget, you can always refer to our spreadsheet when it comes to working out when it pays to be your own fund manager.

Academic research by Barber & Odean examined the performances of portfolios held by US households at a big discount broker between 1991 and 1996. What they found was that the average household turned over 75% of its portfolio every year and ended up underperforming the market by 3.7% annually. The researchers traced the poor performance back to the costs associated with high levels of trading. They said: “Our central message is that trading is hazardous to your wealth.”

Rebalancing factor 2: Tax

If you are investing through a tax-efficient wrapper like an ISA or a SIPP you can buy and sell shares without incurring Capital Gains Tax and potentially trade more frequently. If you aren’t, then CGT is likely to have a very considerable bearing on the regularity of your rebalancing. This year the annual CG tax-free allowance is £10,900. If you crystallise gains (net of losses) beyond that figure then you could be paying tax at either 18% or 28% on your profits. Obviously that’s undesirable and will possibly wipeout whatever theoretical gain was imagined when the rebalancing took place.

In addition, and depending on individual circumstances, there is also the risk of incurring an awful lot of paperwork. Records need to be kept of sales for CGT purposes. Bear in mind that when you trim a winning position you’re retrieving part of the original capital and part of the gain, so a tight audit trail is needed. If you’re doing this with any frequency it could become a headache.

Rebalancing factor 3: Spreads

The third factor to consider in a rebalancing strategy is connected to the nature of the stocks in the portfolio. The crucial point here is the bid-ask spread. This is the difference between the price that’s quoted to buy the share and the price that’s quoted to sell it. It’s another trading cost and one that is influenced mainly by the share’s liquidity (the availability of shares to buy and sell).

Generally, large cap stocks have narrower spreads than small stocks. Indeed, some low liquidity small-cap stocks can have exceptionally wide spreads that make them difficult and expensive to trade. In the book Investment Management, Aswath Damodaran identifies bid-ask spreads as a major hidden trading cost that can make the difference between a successful portfolio and an unsuccessful one:

“...a strategy of buying small over-the-counter stocks or emerging market stocks on information, and trading frequently, might lose a substantial portion of its allure, when bid-ask spreads are factored into the returns.”

Rebalancing factor 4:  Style factors

There are value investors and there are momentum investors - both are persistently successful approaches validated by academics and practitioners. What few investors realise though is that they often work across different timeframes.  

Buying value stocks requires a patient approach, and it’s not uncommon for value investors to hold bargains for two or three years before the ‘value will out’. In contrast, momentum tends to persist over a three month to one year timeframe. Holding momentum stocks for too long can end up being costly - as investors in ASOS and Blinkx discovered painfully earlier this year.

Constructing a sensible rebalancing strategy should take your style timeframe into account.   A combined Value and Momentum strategy should balance between the longer term value effect and the shorter term momentum effect… again a good ballpark may be a one year holding period.

Rebalancing risks

There are numerous strategies for rebalancing a portfolio - whether it’s carried out on a fixed time frame or when a position hits a certain percentage size. But in deciding on an approach it’s vital to take account of the potential costs that could be incurred. Tax, fixed trading fees and indirect costs that can escalate depending on the nature of the stocks in the portfolio need to be watched carefully. That way rebalancing can help you manage risk effectively rather than end up being a profit destroyer.

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