Rebalancing for recovery
The March market meltdown, bond market gyrations, repricing of assets, and the flight to safety over the past couple of months has thrown many portfolios into disarray, particularly those of the do-it-yourself variety. The turmoil is likely to be reflected in increased values for fixed-income and cash holdings in your portfolio. Likewise, your equity values will have declined significantly.
When you add it all up, what you thought was perhaps a 50/50 fixed-income/equity split in your balanced portfolio at the start of the year has become a 60/40 split or even at 70/30 fixed-income/equity split after the first quarter’s carnage.
The net effect is that your overall portfolio risk profile has changed. You are very likely overweighted in low-risk or no-risk assets, such as cash and high-grade fixed income. This is all well and good as a cushion in times of market turmoil. But this turmoil will not last forever. And it’s no time to become complacent about your portfolio.
The net effect is that your overall portfolio risk profile has changed. You are very likely overweighted in low-risk or no-risk assets, such as cash and high-grade fixed income. This is all well and good as a cushion in times of market turmoil. But this turmoil will not last forever. And it’s no time to become complacent about your portfolio.
The major North American stock indexes touched year-to-date lows around March 23. At that point, the S&P/TSX Composite Index had lost 39% from the beginning of the year. But since then, stock markets have staged a steady rally, as the S&P/TSX Composite rallied 32% from March 23 to April 30, leaving it down 15% year to date. It’s too early to say whether this five-week rally is a trend, and sentiment could easily reverse again. But it is an indication of just how unpredictable and fast-moving markets can be.
That’s why it’s important to pay more than the usual amount of attention to your portfolio allocations and rebalance methodically as necessary. Here are the key components a rebalancing review to discuss with your advisor:
1. Asset allocation
How you divide your assets among the three key asset groups (safety, income, and growth) largely determines the return you can expect and the risk that you’re accepting over your expected time horizon. When that allocation is skewed by extraordinary gains or losses in one class or another, as has happened recently, your risk profile will change as a consequence. A portfolio unintentionally overweighted to defensive investments will dampen longer-term returns if left unattended. Talk to your advisor about when to start dipping a toe back into equities to gradually bring your asset allocation back into line with your time horizon, return target, and risk profile.
2. Diversification
Is your portfolio sufficiently diversified in each main asset class? Diversification is at the heart of best practices portfolio planning. It makes no sense at all from a risk-mitigation perspective to have your portfolio allocated 50% to fixed income and 50% to equities, and then have only one bond and one stock in each class. Review your portfolio to ensure individual asset classes contain sufficiently diversified individual securities. In fixed income, for example, you’d spread weightings among federal, provincial, and corporate bonds of different maturities. And in equities, you’d diversify by sector, by region, by capitalization, dividend payment, and so on to achieve your desired risk level.
3. Security selection
When researched, analyzed, and selected properly, individual stocks and bonds within a portfolio work in harmony to achieve a specific purpose, say a minimum dividend yield or a specific target price gain or a specified yield to maturity. When that target has been achieved, the position is usually analyzed to determine whether a switch or change within the portfolio is needed. Extraordinary circumstances, such as the market turmoil caused by the COVID-19 pandemic, may force the issue, causing a sudden wholesale reallocation to defensive assets.
Rebalancing under these circumstances should be a tentative, methodical, and gradual affair. Work with your advisor to determine the best sectors and industries to explore as possible recovery candidates. For example, in the current environment of economic lockdown, your advisor would likely want to look at strong companies in sectors that provide basic needs, such as pharmaceutical and drug manufacturers and other healthcare product suppliers, food retailers and distributors, transportation, freight and logistics, technology companies, including social media, online communication, and telecommunication providers, and, of course the most essential of all, utilities, which are typically regulated and thus provide a steady income stream. As a start, look for healthy cash flow, strong balance sheet (low debt), and steady and growing dividend payments.
Stay away from speculative small-caps in the resources sectors, unless you consider yourself highly risk-tolerant, and willing to lose everything you bet. Aggressive investors with an eye to growth might look at larger-cap energy and mining issues, which are at their nadir at the moment, as both of these sectors are currently virtually shut down. But the oil glut won’t last forever, and the demand for basic raw materials in metals and mining will revive, probably more quickly than most people expect.
4. Mutual fund/ETF review
If, like many investors, you’ve outsourced your portfolio to actively-managed mutual funds or exchange-traded funds, you should review your investment rationale and compare it with the funds’ recent performance. Broader, passive index-tracking ETFs and mutual funds will have fulfilled their mandate and collapsed right along with the indexes they track. But actively-managed offerings should have fared better (that’s why you are paying more the “active” part of the equation).
If they didn’t, find out why. Was there a recent change in fund manager, objective, risk rating, or mandate? For ETFs, was there a change in index methodology or liquidity or ownership? Funds and ETFs are frequently closed, merged, and renamed. If this has occurred to your funds, review the new funds’ mandates to ensure they’ll still deliver what you expected when you first purchased them. If not, consider switching to something more appropriate.
