Article

Impact of frequently rebalancing your mutual fund portfolio

14 Nov 2019

When it comes to your mutual fund investments, there are three distinct things you must understand. The distinction between these three is critical to your portfolio actions. These 3 key ingredients of mutual fund investment are; Portfolio Review, Portfolio Rebalancing and Portfolio Revamp. Let us first look at what these 3 concepts mean and how they actually impact the mutual fund NAV.

  1. Portfolio review is a regular exercise that must be undertaken, irrespective of whether you act on it or not. Ideally, this should be done every year. Here, the mutual fund investment is reviewed vis-à-vis the long term and medium term goals. The portfolio review may or may not justify portfolio rebalancing.

  2. Portfolio rebalancing may be required once in 3-4 years. Rebalancing your mutual fund portfolio is about tweaking your debt/equity mix in such a way as to better achieve your goals. Portfolio rebalancing can be an outcome of your regular portfolio review or a major shift in your risk appetite or macro factors.

  3. Portfolio revamp is the extreme form of portfolio rebalancing. While portfolio rebalancing is more incremental in nature, portfolio revamp is more structural in nature. You must not do a revamp more than once or twice during the entire tenure of the plan and, that too, only in extremely compelling circumstances.

Portfolio rebalancing is actually a trade-off

Typically, portfolio rebalancing has many triggers. For example, your risk appetite may have improved allowing you to take more risk. Alternatively, the macro variables like interest rates and P/E valuations may have changed to an extent that it actually warrants tweaking your portfolio mix. Apart from these external factors, rebalancing may be within the asset class itself. For example, the mutual fund NAV performance may have been consistently below the peer group leaving you with no choice but to rebalance your holdings into another competing fund in the peer group. The reason we call it a tradeoff is that any rebalancing has a cost in terms of transaction costs, tax implications and opportunity losses. That is why your portfolio rebalancing decision needs to be weighed and calibrated. In fact, there are strong reasons you must avoid rebalancing your portfolio on a frequent basis.

Avoid rebalancing frequently – Here are the risks

Rebalancing your mutual fund investment portfolio should fulfill two conditions. Firstly, it must be backed by a thorough review and an acceptance that the original plan is not in consonance with the goals. Secondly, the benefits must exceed the costs; which is why you must understand the risks of rebalancing.

  • The long term financial plan is all about meeting your medium term and long term financial goals. The instrument to meet these goals is a combination of equity, debt and liquid funds. This mix is determined keeping in mind your risk appetite, risk capacity and return targets. Frequent rebalancing could lead to losing sight of the core targets.

  • It needs no reiteration that a well-crafted financial plan is designed to automatically take profits at higher levels and ensuring liquidity at lower levels. This works more as a rule than as an external stimulus. When the checks and balances are already there, it is best left in auto-pilot mode unless there is a strong counter argument.

  • There are costs to rebalancing and these costs matter in the final analysis. When you get out of any asset class, there are exit loads, brokerage costs (if applicable) and statutory charges like stamp duty, STT, service tax etc. When you rebalance your mutual fund portfolio, these costs could hit you both ways.

  • Not to forget there is a taxation implication depending on whether it is an equity fund or a debt fund. Post the 2018 budget, even long term capital gains on equity funds are being taxed at 10% flat without any indexation benefit (above Rs.1 lakh). Debt funds attract higher tax rates and can slice a good chunk of your wealth away.

  • A subtle cost that we do not realize quite often when rebalancing is the opportunity cost of shifting. For example, you may have lived through the downside of an investment and may end up exiting just when it had the potential to turn around. Alternatively, your high duration debt fund may have frustrated you with rising yields, but by exiting at the worst point, you lose out on the benefits when rates fall. These are hard to quantify.

Rebalancing your mutual fund investments is nothing wrong and must be done when your investments are out of sync with your goals. But there are hard questions to answer because the rebalancing needs to make economic sense. More often than not; constant rebalancing has hardly added much value to your mutual fund investments. Patience can be a better answer!

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Impact of frequently rebalancing your mutual fund portfolio

14 Nov 2019

When it comes to your mutual fund investments, there are three distinct things you must understand. The distinction between these three is critical to your portfolio actions. These 3 key ingredients of mutual fund investment are; Portfolio Review, Portfolio Rebalancing and Portfolio Revamp. Let us first look at what these 3 concepts mean and how they actually impact the mutual fund NAV.

  1. Portfolio review is a regular exercise that must be undertaken, irrespective of whether you act on it or not. Ideally, this should be done every year. Here, the mutual fund investment is reviewed vis-à-vis the long term and medium term goals. The portfolio review may or may not justify portfolio rebalancing.

  2. Portfolio rebalancing may be required once in 3-4 years. Rebalancing your mutual fund portfolio is about tweaking your debt/equity mix in such a way as to better achieve your goals. Portfolio rebalancing can be an outcome of your regular portfolio review or a major shift in your risk appetite or macro factors.

  3. Portfolio revamp is the extreme form of portfolio rebalancing. While portfolio rebalancing is more incremental in nature, portfolio revamp is more structural in nature. You must not do a revamp more than once or twice during the entire tenure of the plan and, that too, only in extremely compelling circumstances.

Portfolio rebalancing is actually a trade-off

Typically, portfolio rebalancing has many triggers. For example, your risk appetite may have improved allowing you to take more risk. Alternatively, the macro variables like interest rates and P/E valuations may have changed to an extent that it actually warrants tweaking your portfolio mix. Apart from these external factors, rebalancing may be within the asset class itself. For example, the mutual fund NAV performance may have been consistently below the peer group leaving you with no choice but to rebalance your holdings into another competing fund in the peer group. The reason we call it a tradeoff is that any rebalancing has a cost in terms of transaction costs, tax implications and opportunity losses. That is why your portfolio rebalancing decision needs to be weighed and calibrated. In fact, there are strong reasons you must avoid rebalancing your portfolio on a frequent basis.

Avoid rebalancing frequently – Here are the risks

Rebalancing your mutual fund investment portfolio should fulfill two conditions. Firstly, it must be backed by a thorough review and an acceptance that the original plan is not in consonance with the goals. Secondly, the benefits must exceed the costs; which is why you must understand the risks of rebalancing.

  • The long term financial plan is all about meeting your medium term and long term financial goals. The instrument to meet these goals is a combination of equity, debt and liquid funds. This mix is determined keeping in mind your risk appetite, risk capacity and return targets. Frequent rebalancing could lead to losing sight of the core targets.

  • It needs no reiteration that a well-crafted financial plan is designed to automatically take profits at higher levels and ensuring liquidity at lower levels. This works more as a rule than as an external stimulus. When the checks and balances are already there, it is best left in auto-pilot mode unless there is a strong counter argument.

  • There are costs to rebalancing and these costs matter in the final analysis. When you get out of any asset class, there are exit loads, brokerage costs (if applicable) and statutory charges like stamp duty, STT, service tax etc. When you rebalance your mutual fund portfolio, these costs could hit you both ways.

  • Not to forget there is a taxation implication depending on whether it is an equity fund or a debt fund. Post the 2018 budget, even long term capital gains on equity funds are being taxed at 10% flat without any indexation benefit (above Rs.1 lakh). Debt funds attract higher tax rates and can slice a good chunk of your wealth away.

  • A subtle cost that we do not realize quite often when rebalancing is the opportunity cost of shifting. For example, you may have lived through the downside of an investment and may end up exiting just when it had the potential to turn around. Alternatively, your high duration debt fund may have frustrated you with rising yields, but by exiting at the worst point, you lose out on the benefits when rates fall. These are hard to quantify.

Rebalancing your mutual fund investments is nothing wrong and must be done when your investments are out of sync with your goals. But there are hard questions to answer because the rebalancing needs to make economic sense. More often than not; constant rebalancing has hardly added much value to your mutual fund investments. Patience can be a better answer!