Automatic Rebalancing Your Porfolio Can Send You Broke

We must always question every statement made by fund managers they use in their “marketing” drive to secure more funds under management.

These “assumed truism” may be actually true during parts of the investment cycle. But in other parts of the cycle can send you broke.

What I am talking about here is the idea sold to you by the managed funds of the need to rebalance your asset allocated funds. Automatic rebalancing might be done every quarter and bear no relationship to market activity. As with everything financial, fund managers want to provide the minimum service for maximum cost.

Hence the use of computerized automatic rebalancing of your funds across the asset classes in accordance with your risk profile.

A lot has been said about the need to maintain a balanced portfolio to help protect your nest egg over the long term and maintain your risk profile.

Cynic that I am it seems just another way to gouge more transaction fees from you as the fund managers “rebalance” your investment to maintain your “risk profile”.

We’ve already seen the dangers with buy and hold investing. That denial of the bleeding obvious of getting out of the market when there is a serious downturn and not just assuming you can once again buy the dips to new highs.

The market has a way of sucking you in and then dumping you when it feels like it.

It’s as if fund managers collude with the market to help you slash your financial wrist every 5-7 years (2000-2003) and then you have to trust them to nurse you back to health just in time for your next wrist slashing (2008-).

Rebalancing your portfolio sounds good in theory. In Australia a balanced portfolio can mean you have up to 70% of your assets in risky assets like equities and properties. I have never worked that one out. A balanced portfolio would be 50-50 to me.

Anyway let’s look at how automatic rebalancing works.

What if the equities increase in value and after a few months the allocation is 80/20? There is a 10% out of balance with your investment strategy and risk profile.

At the end of the quarter the automatic rebalancing takes over and will sell 10% of your equity investments and buy 10% more fixed interest or cash assets.

What’s wrong with this?

The sale of equities bears no relationship to market activity. The bull run might still have a long way to go so why sell the assets that are the engine of your retirement fund? They should stay in and protect the investment with hedging or stop losses. Hanging on to your winners as an investor makes sense to me.

That’s not so bad. It’s what happens when the market crashes that can really hurt you. That is the real problem.

Fund Managers are generally reluctant to admit a bear market exists and will keep rebalancing your portfolio as the market goes down, taking transaction fees all the way. It’s called throwing good money after bad in my book.

Assume Equities have fallen 50% (round figures). And let’s assume you had 70% of your money in equities. That means you have lost 35% or $35K which equates to the Equity investments dropping from 70% to 54% of your balanced portfolio.

With only $65K left in your fund it will need rebalancing.

Amount in Fund Equity Investments Fixed Interest Balance
$100K 70% 30% 70/30
$65K 35% 30% 54/46
$65K 70% (45.5%) 30% (19.5%) 70/30

In order to stick to your “balanced” portfolio and risk profile your fund manager will automatically sell approximately 10% of your “safe” fixed interest assets to purchase more “risky” equities to restore the 70/30 balance at the end of the quarter.

If the market falls further then next quarter it will be done again. Averaging down is not good in a bear market.

Also they may well be selling fixed interest assets at the wrong time too and take a loss on those in order to buy more falling equity assets. Interest rates have been falling at the same time.

This sound dumb to me.

At what point is this justified? In my view it cannot be justified. The market is falling so they move money out of safe assets into risky (falling assets). That doesn’t not make much sense to me.

In this example I have done the calculations when the market had fallen 50%. But it will probably happen as the market falls each quarter. Computerised rebalancing is often scheduled to take place at the end of a quarter.

Why? I think it just is.

The problem here is that is often the most volatile time for your portfolio as fund managers buy and sell equities like crazy trying to lock in profits for their quarterly bonuses. Automatic rebalancing should be done mid-term in a quarter, if at all. It should also be done with respect to market activity.

In my own case I redeemed most of my money from my managed funds in December 2007. There was about $60K still to come from an overseas fund. The money was in my cash fund by early January 2008. Everyone was on holiday except the computer which re-allocated the $60K into the funds I had just redeemed the rest of my retirement fund from.

At the time I had no idea the $60K was reallocated. What was worse though was I checked the value of my portfolio about mid-January as I still could not contact anyone responsible for my account. The value of the $60K left in the funds had dropped by about $8K because in January 2008 the market dropped sharply.

My account was charged transaction costs on re-allocating the $60K into the funds I had originally. Then it was charge another fee to redeem the $60K. I complained and it was March when I was finally paid out. They made good the loss for January and refunded the transaction costs after several conversations and letters of complaint.

If you have automatic rebalancing of your portfolio you might want to consider turning it off and making the decision to rebalance after due consideration of market activity.

Read this article on, “3 Must Read Guidelines on Rebalancing Your Portfolio“, then make up your own mind.

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