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NEWS - PLANNING
How to manage your portfolio now
10/1/2001
Every day for a week after the terrorist attacks on the World Trade Center and the Pentagon, MLC Investments was buying into the Australian and US sharemarkets.
It wasn't buying because it perceived any fundamental shift in the outlook for those markets. Rather, it was buying because as the overall value of the markets fell, the proportion of MLC's diversified funds that was invested in equities began to shrink.
MLC is a highly active exponent of a strategy known as rebalancing. Having decided how much of its funds' money should be invested in equity markets over the long term, it puts more money in when markets fall and when they rise it takes money out - it rebalances its portfolios - to bring the allocation back in-line with its target levels.
Rebalancing portfolios is a strategy being recommended to a growing number of individual investors who have a long-term plan but are uncertain exactly what to do next.
The process for individuals needn't be as intensive as it is for professional managers. MLC, for example, rebalances a portfolio if its allocation drifts more than 2 per cent away from its long-term targets.
Starting on September 13, MLC began moving its diversified funds' holdings out of cash and fixed interest and reallocating the money to equities. By September 20 the process was complete, and the funds were back to within acceptable ranges of its long-term settings. There they have remained, being constantly rebalanced as markets move up and down.
The head of technical and advisory services for Bridges Financial Services, Ross Johnston, says that under normal conditions, individuals really need revisit their portfolio's asset allocation only once a year. But he says: "It's definitely worthwhile having a look right now.
"Investors will have seen the equity portion of their portfolio shrink with the recent downturn. They will now be asking the question, 'Should I move my assets to a more defensive portfolio, should I do nothing or should I take the contrarian approach and invest more aggressively?'
"Investors should generally have a longer-term investment strategy that they and their financial planner have established together. In conditions of market volatility investors should look at what their long-term strategy has been established to do.
"If the mix of assets is consistent with the long term then there is no need to take any action. If the strategy has 'drifted', then it is worth bringing the strategy back to the objective."
But Johnston warns investors should not take any action without seeking advice from their financial planner.
The action an investor might take will depend on how his or her portfolio is structured. If the investor holds a range of sector-specific funds - funds that invest in only one asset class - he or she will probably need to undertake the rebalancing themselves, in conjunction with an adviser.
But if an investor holds balanced funds, which invest in a number of different asset classes, "the fund manager will be rebalancing the portfolio as part of its management functions".
The general manager of MLC Investments, Chris Condon, says that under normal circumstances the manager rebalances portfolios "just by directing cash flow into the areas where we are underweight".
That's not always possible for an individual investor, says Johnston, unless they are making regular contributions to a fund, or have sufficient cash reserves to top up the underweight asset class.
However, it's only worth worrying about a portfolio's asset allocation going skewwhiff if it was set correctly in the first place. If there's no long-term plan, there's no point of reference to bring it back in line with - or, as the US baseballer Yogi Berra famously put it: "You've got to be very careful if you don't know where you're going, because you might not get there." Condon says a sensible asset allocation is necessary for all investors "to make sure you're invested with the degree of risk that's suitable for you - to place yourself in the right position on the 'efficient frontier'".
The efficient frontier is represented on a graph that plots the return from a particular market or specific security against the risk associated with that market or security. Asset allocation aims to maximise the return that an investor generates for the amount of risk that they take - hence the use of the term "efficient".
The chief investment officer for AusBIL Dexia, Mike Wilson, says risk is defined as the potential variation in returns from a particular asset class or security. In general terms, cash is the least risky of the major or mainstream asset classes, and equities are the most risky.
"Risk is the volatility of markets," Wilson says. "In the case of equities it comes in at about 15 per cent a year. In a 'normal' year you get about 10 per cent, but the range of likely returns is from 25 per cent to -5 per cent."
The volatility of an equity market can be dampened in a portfolio by diversifying into other, less risky asset classes, such as fixed interest or cash.
When an investor - whether it's an individual, a professional fund manager or a superannuation fund - has decided how much risk they're prepared to accept, the concept of the efficient frontier lets them come up with an asset mix that will produced the best long-term return for that level of risk. As the accompanying charts show, different asset mixes produce quite different expected risk and return trade-offs. If the asset mix of a portfolio drifts away from its long-term ideal, the risk changes as well, and that's where the concept of rebalancing comes into play.
Wilson says sometimes markets get slightly out of whack, and in those circumstances investors can achieve a return that's better than might otherwise be expected for the level of risk associated with holding a particular investment.
In those cases, the temptation to rebalance should be resisted. Deviating consciously from a long-term benchmark is known as tactical asset allocation. It's not necessarily a technique recommended for individuals, but it's an approach used by many fund managers to try to achieve superior returns compared to a particular benchmark without taking any more risk.
Rebalancing can have unpleasant unintended consequences if not handled smartly, Condon says. Transaction costs, for example, can exert a drag on fund returns, and taking profits can result in the generation of realised capital gains, potentially triggering a tax bill.
All of these possible downsides need to be weighed up against the perceived problems caused by a portfolio drifting away from its long-term asset allocation, Condon says. "I think the most important thing is making sure their strategy remains consistent with their long-term wealth creation objectives," Condon says.
Even though an active rebalancing strategy tends to reduce exposure to a market as it rises (and possibly becomes overheated), Condon says it shouldn't be confused with a strategy known as "market timing".
He says the idea of trying to pick the high and low points of any market is "absolutely crazy. Market timing involves a small number of very large decisions," he says.
"It's like tossing a coin and putting your paypacket on whether you get a head or a tail. It's a big decision, compared to saying we're going to have 20 tosses of a coin and I'm going to put 5 per cent on each one.
"You can have skill at making big decisions, but you can still be very unlucky."
In a comparison of rebalancing versus trying to chase the best returns, MLC estimates that over a period of 11 years (1990 to 2000 inclusive), an investor with a $100,000 portfolio invested 30 per cent in Australian shares, 20 per cent in international shares, 15 per cent in property and 35 per cent in Australian fixed interest would come out $111,000 ahead of an investor who chased the best performing asset class each year.
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