In perfect balance: Different approaches to rebalancing pension portfolios

Rebalancing a portfolio back to its target mix is an essential function of an investment committee. It ensures that the portfolio’s risk profile remains consistent with the risk tolerance established by the investment committee and prevents the fund from being exposed to undesirable risks.

In steadily rising or falling markets, rebalancing will create a small drag on portfolio returns. For example, the strong equity boom markets experienced in the 10 years following the credit crisis would have increased portfolio equity allocations, and enhanced returns, over time in a portfolio that did not rebalance. Similarly, in a steadily falling equity market, failure to rebalance will continue to reduce the exposure to the underperforming asset class. However, in most markets, when relative asset class returns fluctuate, a well-defined rebalancing practice should add value to the portfolio, while at the same time, controlling portfolio risk. In other words, a formal rebalancing requirement for an investment committee to buy low and sell high is the recipe for a successful investor.

A perfect example of the benefits of rebalancing is illustrated in the recent coronavirus-induced market selloff. The coronavirus shutdown represented a difficult environment for pension committees to meet and react. Many pension funds without formal rebalancing strategies or implementation protocols did not address this issue, to the detriment of their pension fund returns.

The coronavirus-related closures triggered panic selling across all risk-related asset classes. For example, the Toronto Stock Exchange lost 37 percent of its value from its February peak to the crisis low point on March 23rd. The Canadian bond market experienced mixed results, with government bonds benefiting from a flight to quality, while corporate bonds were hurt by credit spread widening. The net impact was a smaller reduction in the FTSE Canada universe bond index, which lost 10 per cent of its value over that same period. The equity market sharply corrected in the second quarter of 2020, reacting to the government stimulus and to the reopening plans, rebounding in the second quarter alone by 17 per cent (and 38 per cent from its low).

A portfolio invested 60 per cent in the TSX index and 40 per cent in the FTSE Canada universe bond index on Dec. 31, 2019, would have lost 2.5 per cent of its value over the first six months of 2020. However, if the investment committee had rebalanced the portfolio when equity markets were at their lowest, the portfolio return would have been negative 0.5 per cent. By rebalancing during the market correction, the fund risk characteristics would have remained better aligned with the investment policy and the fund would have experienced a two per cent higher return.

There are costs associated with rebalancing a portfolio. Rebalancing takes time and incurs transaction costs, including trading commissions and bid/ask spreads. Accordingly, a pension committee should not rebalance needlessly. The following are some common rebalance approaches that balance the need to keep portfolios in line with the policy, while avoiding unnecessary cost and complication:

Fixed intervals: Some investment policies will require the portfolio rebalancing to occur at fixed intervals. For example, a quarterly rebalancing policy will automatically rebalance the portfolio back to the benchmark at the end of each quarter. The benefit of this policy is that it will keep the portfolio consistently in line with policy. The weakness is that it may trigger a rebalancing when the portfolio is not far out of alignment.

Fixed percentages: Some policies will rebalance the portfolio when the drift exceeds a fixed percentage. For example, a portfolio rebalance may be triggered when equity allocation exceeds the targets by more than five per cent. A challenge with this approach is that the portfolio will require daily monitoring, to ensure that the threshold has not been breached.

Fixed intervals with a fixed percentage tolerance: This approach will review the mix on a quarterly basis, but only rebalance where the mix exceeds the policy by a fixed percentage. For example, a rebalance could be required quarterly, only where the equity allocation is five per cent or more beyond the policy target. This will limit the rebalancing to cases where the mix is significantly outside of policy targets.

Rebalancing with cashflows: This method involves using cashflows to rebalance the portfolio. If for example, equity weightings have drifted higher, contributions would be invested in fixed income and benefit payments would be made from equity holdings. In this way, a plan with regular cash flows could keep the portfolio close to its asset mix, without incurring the costs associated with a formal rebalancing. In an extreme case a formal rebalancing might still be necessary, where there is significant drift which cannot be properly addressed through reallocating regular cashflows.

The rebalancing policy should also consider the allocations between portfolio managers. For example, where more than one investment manager is employed within an asset class, the balance of the funds between the two managers may drift when one investment manager outperforms the other. When a formal rebalancing is undertaken, the allocations between managers should also be addressed.

Overall, asset allocation policy is extremely important, as it ensures that the risk and reward potential of an investment strategy is aligned with the investor’s risk tolerance, time frame and portfolio goals. Adopting a disciplined approach to rebalancing is essential for a pension fiduciary to ensure that the portfolio is not exposed to unintended or excessive risk.

Colin Ripsman is the founder of Elegant Investment Solutions. These views are those of the author and not necessarily those of the Canadian Investment Review.