In a difficult year such as 2022, rebalancing between asset classes that are declining may seem a futile exercise. But rebalancing, even in down markets, remains vital to keeping a portfolio within the right risk/reward ratio and is a key element of the value that an advisor can provide to their clients.
Why? Well, markets that go down then invariably go up. And it’s hard to know when the tide will turn. When markets shift, a portfolio that has moved away from its designated risk/reward ratio may not perform as the investor may expect. The investor may be exposed to too much risk for their comfort level, or too little risk and potentially less reward. An advisor who keeps a portfolio on its intended track can help the investor stick to their plan. But because rebalancing is a regular duty, many advisors (and investors) don’t realize its true value.
That’s why we have produced our Value of an Advisor study every year for the past decade. We believe there are distinct ways that advisors provide value to their clients – value that is above and beyond the fees they charge. We also believe that many advisors find it difficult to not only quantify that value but communicate it.
This is where Russell Investments comes in. Our annual study both quantifies the value that advisors can add through the holistic wealth management services they may provide, and it shows advisors how to communicate that value to their clients.
We do this through our relatively simple formula:
This is the first of a series of blogs that will do a deeper dive into each of the components of our Value of Advisor study. In this blog, we will look at the importance of Active Rebalancing.
The first letter of our formula stands for Active Rebalancing, a routine part of the traditional management of investor portfolios. As we can demonstrate, rebalancing (or not) can have a substantive impact on a portfolio.
Rebalancing can add value in three ways:
1) in maintaining an investor’s mix of assets to the original allocation
2) in potential return
3) in reducing volatility.
In this year’s study, the value of rebalancing was weighted toward the role it plays in keeping the strategic asset allocation on track - and therefore remaining appropriate for the investor’s stated goals. Regular rebalancing also provided slightly higher risk-adjusted returns and reduced volatility.
First, let’s consider the impact on the investor’s asset allocation. For example, if an investor had purchased a hypothetical balanced portfolio of 60% equities and 40% fixed income in January 2009 and it had not been actively rebalanced since then, by the end of 2022 the profile of the portfolio would be substantially different. That original balanced portfolio would have become a growth portfolio, with approximately 82% invested in equities and only 18% in fixed income. With that kind of imbalance, the investor could have experienced a significant drawdown during the kind of equity market retreats we’ve seen in the past few years.
But the real risk is the huge overweight in growth stocks. From an initial 15% allocation, the weighting of U.S. large-cap growth stocks in this hypothetical portfolio would have ballooned to 35%. While that would have propelled the portfolio higher for most of the decade, it was detrimental in 2022. The Russell 1000 Growth Index lost more than 29% in the year while the Russell 1000 Value Index only lost 7.5%.
If you don’t think regular rebalancing has value, imagine the 2022 review conversation with a client whose portfolio had become so heavily weighted in U.S. growth stocks compared to the conversation with a client whose portfolio had been rebalanced back to the initial allocation.
Portfolio: U.S. large-cap = Russell 1000® Index; U.S. small cap = Russell 2000 Index; non-U.S. developed = MSCI EAFE Index; Emerging markets equity = MSCI Emerging Markets Index; REITs = FTSE NAREIT All Equity REITs Index; and fixed income = Bloomberg U.S. Aggregate Bond Index. For illustrative purposes only. Not intended to represent any actual investment.
It’s a pretty good bet that over the past decade or so, most investors would only have focused on the benefit of the increased allocation to U.S. growth stocks and how that would have driven strong returns in previous years. They wouldn’t have considered the increased risk until the markets turned. If advisors don’t discuss the importance of rebalancing, then we can’t expect investors to understand its value.
The value communication gap
We consistently find there’s a big gap between what investors believe advisors do and what advisors actually do. In other words, there’s a value communication gap between advisors and their clients. But wouldn’t it be great if you could tell your clients that by regularly rebalancing their portfolio, you have maintained their asset allocation in line with their stated risk appetite while also helping smooth out returns?
How to tell the rebalancing story
Are you sharing your rebalancing strategy consistently with your clients? Are you letting them know how frequently their portfolios are rebalanced, whether you are doing it manually or whether it’s the rebalancing policy of the model-strategy partner you’re working with? We recommend four simple touchpoints to make communication both easy for you and meaningful for your clients.
- The potential benefits of an active rebalancing policy—Explain what can happen if rebalancing isn’t done (last year is a great example) and how rebalancing regularly helps keep portfolios on track with their goals and their risk profiles.
- What the rebalancing policy is—Let your clients know the basics of the policy, and how it works to be both efficient and oriented toward their desired outcomes.
- How frequently the portfolios are rebalanced—Explain how often you will rebalance their portfolio and why you believe that frequency makes sense for them.
- The importance of actively rebalancing during periods of the market volatility—Let your clients know how taking actions that may seem counterintuitive – such as reducing their exposure to the fastest-growing segments of the market - can help them
avoid costly mistakes, such as following the herd, buying high and selling low, and leaving the market at the worst times.
The bottom line
In the formula of advisor value, A is for actively rebalancing investor portfolios. As we have shown, rebalancing can help maintain an investor’s established asset allocation, it has the potential to boost returns and it can help smooth out volatility. And that in turn can help investors meet their desired financial goals. That is valuable and is something investors should understand. We think you should let them know.
Disclosures
These views are subject to change at any time based on market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
This material is not an offer, solicitation, or recommendation to purchase any security.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
Please remember that all investments carry some level of risk, including the potential loss of the principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.
Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.
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