As the end of the year approaches, the investment industry is gearing up for the annual portfolio rebalancing act. An article in InvestmentNews gives the following example:

Still, advisers’ plan to stick to their long-term asset allocation was likely thrown out of whack this year by the divergence of stocks and bonds. For example, a client who started the year with a simple 60/40 portfolio comprised of the $287 billion Vanguard Total Stock Market Fund (VTSMX) and the $247 billion Pimco Total Return Fund (PTTAX), the two largest mutual funds in the world, would now have 66.3% invested in stocks and just 33.7% invested in bonds, pushing beyond the typical 5% leeway most advisers give their asset allocation.

To illustrate the divergence from asset allocation historical averages, here is a chart from a Vanguard blog post:

Mutual Fund and ETF Assets under Management

While the collective allocation of mutual funds and ETFs to equities has recently reached 57%, the biggest divergence from the historical median is in international equities. Allocation to bonds is also relatively high, while the proportion in domestic equities is close to the 20-year median.

The higher allocations to international equities and bonds are at the expense of cash. Assets in money market funds are at a historical minimum of about 18% in the observation period. This has undoubtedly been caused by the low interest rate policy of the Fed, which depressed returns of such funds. The danger is that when interest rates eventually rise, bond prices will suffer:

So in an intermediate-term bond fund, with an average duration of four to five years, the loss would be about 4% to 5%.

This means that it may actually be prudent for an average investor to shorten the duration by moving a part of investment in bonds to money market funds.

Historically, the proportion of international equities in the total equity allocation has been about 19%; currently, it is about 27%. The argument for keeping it high is a relatively low valuation of foreign stocks compared to domestic ones:

Stock Valuation per Market Region

When rebalancing portfolios, it is also important that investors understand the true exposure of their mutual fund holdings to various asset classes. The recurring problem, which Alpholio™ addressed in several prior posts, is that managers in some equity funds (especially value strategies) hold a large percentage of assets in cash. As a result, asset allocation in the overall portfolio can be distorted unbeknownst to the investor.

Alpholio™ provides current information on the exposure of mutual funds to various asset classes. This information is not obtained from the regulatory filings or selective disclosures of fund holdings, which suffer from a number of problems.

In sum, when rebalancing a portfolio either on a fixed schedule or as a result of divergence from prior allocations, investors should take into account a broader market and interest rate context, rather than just follow rigid rules.

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