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How and When to Rebalance Your Mutual Fund Portfolio?

With time, asset classes move up or down, leading to changes in asset allocation proportion. Hence, we need to rebalance our portfolio from time to time. This article focuses on how and when to rebalance your mutual fund portfolio.
How and When to Rebalance Your Mutual Fund Portfolio

Rebalance regularly to maintain the Asset Allocation

Asset allocation requires investors to invest in various asset classes in a specified proportion as per their risk profile. With time, asset classes move up or down, leading to changes in asset allocation proportion. Hence, we need to rebalance our portfolio from time to time. This article focuses on how and when to rebalance your mutual fund portfolio.

Before we understand how and when to rebalance the investment portfolio, let us briefly discuss asset allocation and portfolio rebalancing concepts.

What Is Asset Allocation?

Asset allocation is diversifying an investment portfolio into various asset classes to reduce the risk and earn optimum returns. An investor can diversify their portfolio into various asset classes such as:

  1. Domestic equity mutual funds
  2. International equity mutual funds
  3. Fixed income
  4. Gold, silver, and other commodities
  5. Real estate
  6. Alternative investments like art, collectables, cryptocurrencies, Non-fungible Tokens (NFTs), etc.

Asset allocation requires assigning a specific percentage of the portfolio to various asset classes based on an individual’s risk profile, age, time left to achieve financial goals, life events (marriage, childbirth, etc.), etc.

What is Portfolio Rebalancing?

Once an investment portfolio has been built based on asset allocation, it cannot remain static. Over time, the weight of the asset classes will move up or down based on their performance, and each asset class's asset allocation percentage will change. If an asset class has moved up substantially, its position in the overall asset allocation will be overweight more than the base allocation. Similarly, if an asset class has moved down substantially, its position in the overall asset allocation will be underweighted than the base allocation.

Portfolio rebalancing is regularly reviewing the overweight and underweight positions of each asset class in the overall investment portfolio and accordingly making changes to bring them back to the base asset allocation.

Table: Example of portfolio rebalancing

Rebalance_Portfolio_1

(Source: https://www.businesstoday.in/markets/top-story/story/worried-about-market-crash-time-to-rebalance-your-portfolio-323819-2022-02-24)

The above table shows how an investor can start with a base asset allocation. During the year, assuming equity falls 20%, at the time of portfolio rebalancing, the investor can:

  1. Sell some debt and gold investments, and invest the sale proceeds into equity or
  2. Make future investments in equity to avoid selling existing debt and gold investments

Either of the above portfolio rebalancing options will lead to equity underweight position reverting to base (50%), debt and gold overweight positing reverting to base.

Why should you do Portfolio Rebalancing?

Portfolio rebalancing can help investors earn better returns than a one-time asset allocation. Let us understand this with the help of an example.

An investor invested Rs. 1 lakh in equity (70%) and debt (30%) in 1998. He made the equity investment in the Nifty 50 Index and debt investment in the Nifty 10-year G-Sec Index. Let us see what happened if he did a one-time asset allocation or annual rebalancing.

Chart: One-time asset allocation vs annual portfolio rebalancing

Rebalance_Portfolio_2

(Source: https://www.miraeassetmf.co.in/knowledge-center/how-does-portfolio-rebalancing-happen)

The above chart shows, at the end of 2019:

  1. The value of the one-time asset allocation portfolio was Rs. 9.74 lakhs
  2. The value of the annual rebalancing portfolio was Rs. 12.50 lakhs

So, the above example shows an annual portfolio rebalancing exercise to maintain base asset allocation can help you earn superior returns than a one-time asset allocation portfolio.

When should you Rebalance your Investment Portfolio?

Portfolio rebalancing can be done either annually or based on some event.

1. Annual portfolio rebalancing

  • You can do your portfolio rebalancing at the start of every financial year in April. During the annual review, if any asset class is overweight, you should sell some portion to bring it back to the base asset allocation percentage. The sale proceeds can be invested in other asset classes that are underweight. It will bring up those asset classes to the base asset allocation.
  • As your age increases, you should adjust the base asset allocation every passing year. Likewise, you should reduce the exposure to equity and increase debt exposure every passing year.

2. Event-based portfolio rebalancing

  • Apart from annual portfolio rebalancing, significant events may necessitate portfolio rebalancing. Some of these significant events include war (for example, the Russia-Ukraine war), pandemic (for example, Covid-19), Union Elections, etc. 
  • When uncertainty surrounds a significant event, you may have to temporarily tweak the portfolio until the event has passed. During the uncertain period, equity is vulnerable. So you may reduce its percentage. Similarly, gold is considered a haven, and it does well. So, you may increase its percentage.

Introducing a new financial product may also require portfolio rebalancing to make space for the new product to be included in the investment portfolio. For example, real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) were introduced a few years back. It required investors to reduce asset allocation to existing asset classes to allocate some investment to REITs and InvITs. Similarly, AMCs launched silver ETFs and fund of funds (FoFs) in early 2022. So, investors had to allocate some gold percentage to silver or reduce exposure to other asset classes to make space for silver investments.

How to Rebalance a Portfolio?

In the earlier sections, we have seen why and when to rebalance your investment portfolio. Now, let us understand how to rebalance your investment portfolio. Some of the ways of portfolio rebalancing include:

  • Reverting to base asset allocation
    • An individual may start with a base asset allocation. For example, allocate 70% to equity and 30% to bonds. Over the year, both the asset classes may move up or down. At the portfolio rebalancing, the overweight asset class is sold, and proceeds are invested in the underweight asset class. It ensures the overall asset allocation reverts to the base (70% equity and 30% bonds).
    • Image: Portfolio rebalancing – Reverting to base asset allocation
Rebalance_Portfolio_3
  • Rebalancing based on fundamentals of the asset class
    • An investor can do portfolio rebalancing based on the fundamentals of the asset class and the future outlook based on specific events. For example:
      • Equities may have seen a sharp fall due to an event like a pandemic, war, election, recession, etc. As a result, the valuation may be much lower than long-term averages. During such events, when valuations are low, you can rebalance your portfolio by increasing allocation to equities due to cheap valuations.
      • Long-duration debt funds are sensitive to market interest rate movements. In a falling interest rate regime, bond prices move up. You can rebalance your portfolio during such times by increasing allocation to long-duration debt funds to benefit from increasing bond prices.
      • Gold is seen as a haven during uncertain events like a pandemic, war, election, recession, etc. Gold allocation can be increased during such events by reducing the equity allocation (as equity is vulnerable during such events).
  • Dynamic asset allocation
    • Rather than doing portfolio rebalancing annually or based on some event, you can assign this task to a mutual fund scheme manager by investing in a dynamic asset allocation fund or a balanced advantage fund. These schemes manage the asset allocation dynamically based on pre-set criteria such as the P/E ratio (price to earnings ratio), P/B ratio (price to book ratio) or other internal criteria.

Factors to consider while portfolio rebalancing

While doing the annual portfolio rebalancing exercise, you should consider the following factors that may necessitate a change in the base asset allocation.

  1. Age
    • As your age increases, your risk-taking ability will reduce every passing year. Hence, you should regularly revise your base asset allocation to factor in reduced risk-taking ability with increasing age. Therefore, you should progressively reduce equity allocation and increase debt allocation.
  2. Life events
    • Life events such as marriage, childbirth, purchasing a house (on a home loan), etc., can impact the risk-taking ability. Therefore, during the portfolio rebalancing exercise, such events should be factored in, and you may make appropriate changes in the base asset allocation.
  3. Time left to achieve goals.
    • As you move nearer to your financial goals, you should reduce the equity component for that financial goal and increase the debt component. Ideally, three years before the goal date, you should move the entire money to debt.

Taxation impact on portfolio rebalancing

The portfolio rebalancing exercise will have a tax impact when you sell any assets. Hence you should consider the tax implications of the portfolio rebalancing exercise. Rather than selling assets, you may invest fresh money for the portfolio rebalancing exercise to avoid capital gain tax implications.

Investing in financial goals with the Glide Invest App

In the above section, we understood what portfolio rebalancing is, why, when, and how. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals

With Glide Invest, you will get guidance for:

  1. A personalised risk profile assessment
  2. Identifying your financial goals
  3. Appropriate asset allocation
  4. Making a financial plan for each goal
  5. Automating the financial plan
  6. Review and analysis of your financial plan 
  7. Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App!

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