Profit Driven Portfolio Rebalancing

Profit Driven Portfolio Rebalancing

At times when certain asset classes, such as equities, appreciate quickly, investors face an important question—whether to maintain their asset allocation or trim exposure to capture capital appreciation and invest the proceeds in other asset classes. Although the answer can vary depending on individual circumstances, in my work as a wealth advisor at Neuberger Berman I’ve found that  reallocating based on asset class appreciation can be effective in lowering portfolio volatility and keeping clients on track toward reaching their financial goals. Below, I provide a window into this approach.

Rebalancing Asset Class Allocations Driven by Client Specific Rates of Return

Any rebalancing decision involves a range of considerations including the goals, time horizon and risk tolerance of the client, his or her liquidity needs and the availability of investments that could provide a favorable replacement for the assets sold. As an advisory team within Neuberger Berman, we are able to draw on the insights of the Firm’s Asset Allocation Committee, which provides quarterly views on an array of asset classes, as well as our Investment Strategy Group, which can build allocation models and assess the compatibility of the various portfolio managers we might utilize.

Within this framework, our team not only addresses decisions on whether to rebalance based on long term asset allocation targets but also addresses client specific considerations. For example, to the extent clients have a specific annual performance target in mind, we can work with them to realize gains in appreciated asset classes and rebalance into lower-risk asset classes in an effort to help manage their distribution needs. This process does not need to coincide with a calendar cycle that is indifferent to the ebbs and flows of capital markets and can be implemented any time individual segments of an overall portfolio experience a period of positive performance. For example, many charitable entities have a payout requirement of 5% or more. In the event the total performance of an overall portfolio exceeds this amount, there may be an opportunity to realize gains in certain segments of the portfolio, which can help clients manage payout requirements or, conversely, provide a cushion to help mitigate downside risk.

The result of this approach is binary in that capital markets or asset class segments could continue to appreciate or falter. For example, in the scenario where equities have appreciated and there is a rebalancing away from equities into lower-risk asset classes, should equities climb higher upside opportunity will be foregone. However, investors who choose not to realize gains and rebalance are, in a sense, making an active tactical allocation decision. These semi-active allocation decisions could leave investors overly exposed to riskier asset classes.

Where Do You Put the Proceeds?

With any decision to rebalance as a result of asset class appreciation, a key question is: “Where do you put the proceeds?” The answer is driven typically, in part, by long term asset allocation targets, as well as the timing of any client specific needs such as upcoming withdrawals or distributions. One significant challenge is today’s negative real yield environment. A frequent goal of rebalancing is to help maintain the purchasing power of real distributions (i.e., accounting for inflation).

With cash yields near 0% (and negative on an inflation-adjusted basis), the redeployment of appreciation proceeds to cash is often unappealing. For investors willing to take some risk or for those investors who have asset class exposure requirements, there are a number of options to consider in lieu of reallocating to cash or conservative fixed income. Some appealing options include: 

Lower Volatility Approaches

  • Lower volatility arbitrage strategies:These managers seek to exploit pricing discrepancies between securities and earn the “spread” (e.g., the pricing difference between two securities). Further, these strategies are not subject to the same duration and convexity risks that are a major concern with investment grade fixed rate bonds.
  • Non-investment grade corporate bonds: Real yields in the non-investment grade corporate bond market are 4.8%. While non-investment grade bonds and bank loans are not subject to the same degree of interest rate (i.e., duration) risk as investment grade bonds, they are subject to higher default risk. A question is whether the roughly 40 basis points of monthly real yield compensates investors adequately for assuming these risks. However, with corporate balance sheets flush with cash, the general outlook is for default rates to remain near historic lows in the near term.
  • Long/short equity: For investors who want to maintain equity exposure but are looking to mitigate some volatility, a long/short strategy might make sense. This is particularly the case for clients who may have equity exposure requirements.  A common philosophy of long/short strategies is that downside mitigation is pivotal to the long term return profile. For the 10-year period from January 1, 2002 through December 31, 2011, long/short strategies, as measured by the HFRI Equity Hedge (Total) Index, provided investors with an annual return of 4.6% versus 2.9% for the S&P 500 with 45% less volatility. There are various long/short equity vehicles including mutual funds and alternative investment vehicles for qualified investors.  

In conclusion, employing a long term investment horizon is important to overcoming short term volatility that could otherwise derail an investment plan. However, at the same time, I believe that opportunistic rebalancing can be an effective tactical tool.  Investors who take a passive “buy and hold” approach are, in my opinion, actually making a semi-active allocation decision and forgoing opportunities to rebalance in line with long term allocation targets or to address client specific distribution needs.

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Neuberger Berman LLC is a Registered Investment Advisor and Broker-Dealer. Member FINRA/SIPC. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.

© 2012 Neuberger Berman LLC. All rights reserved.

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