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Rebalancing helps manage risk

Wouldn’t you love a strategy of selling high and buying low?

Naturally we have the tendency to want to let our winners run without taking profits.

On the flip side, a good stock might be going through a rough patch and, rather than sell the stock, adding to it might be the right move.

Creating a disciplined rebalancing process begins with determining the portion of your investments in cash, fixed income and equities.

Below we have mapped out our general structure rule with respect to the equity component. A holding is common shares in a single company (for example, Canadian Pacific Railway or Apple).

Clients who have between $500,000 and under $2.5 million will typically hold a minimum of 25 holdings. An optimal number of holdings is 30, and no greater than 35 holdings.

Portfolios between $2.5 million and $5 million we recommend holding a minimum of 30 holdings, optimal number of holdings is 35, and no greater than 40 holdings. We use the term “optimal” to describe the dollar amount invested in each company in normal markets conditions.

Reba Watson has a portfolio valued at $1.4 million. She has a moderate growth portfolio where 80 per cent, or $1,120,000, are held in equities. Based on her portfolio size and being moderate growth, we can illustrate rebalancing.

Optimal positions size

$37,333 (essentially the equity portion of $1,120,000 divided by 30). Without going through this exercise, one would not know what a normal position size is. I have heard people say I purchase 100 shares of everything. That simply does not work for a host of different reasons. The most obvious reason is that some stocks trade at very low prices/share and others at much higher prices.

Half position size

$18,667 (essentially half of the optimal position size). Sometimes we wish to underweight a holding or overweight a holding from a strategic sense in the short term. If we feel that the markets are getting long in the tooth, or late in the bull market cycle, then reducing position sizes can be a strategic decision. This reduction would help if markets declined or had a correction. Another example of utilizing half position sizes may be a new client that has never invested before, to get the level of comfort up we may suggest half positions sizes to begin with. As time goes on, we would typically work toward optimal positions sizes.

Rebalance position size

$44,800 (essentially the equity portion of $1,120,000 divided by 25). If the long term goal is no fewer than 25 names this is a natural starting point to calculating your rebalancing number. Whenever we are reviewing portfolios, one of the first items we look at is position size and if any holdings need to be rebalanced. For example, we purchased $35,000 of Microsoft initially for a client. Today, we see that the position size for Microsoft has increases to $47,744. At a minimum, we would recommend to reduce the position by $2,944 (down to the rebalance positions size) or reduce the position by $10,411 (down to the optimal position size).

Excessive position size

$70,000 (this is calculated taking the total portfolio value of $1.4 million and multiplying by five per cent). If a client chooses to take an excessive holding in one company we document the extra risk incurred within the Investment Policy Statement (IPS).

Rebalancing frequency

Over the years, several studies have been done to determine the frequency of rebalancing reviews. Should investors rebalance quarterly, semi-annually or annually? As the markets vary from year to year, the frequency should be adjusted based on current conditions. Rebalancing asset mix and individual position size can normally be done at the same time. Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review your Investment Policy Statement (IPS) to ensure that you are comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your wealth adviser when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may result in your optimal asset mix needing to be adjusted.

Rebalancing to Investment Policy Statement

When an Investment Policy Statement is set up the optimal asset mix is outlined. To illustrate, we will use Reba, who invested in a portfolio with the following asset mix —fixed income 20 per cent and equities 80 per cent. Asset classes do not change at the same rate. Over the last year, equities grew faster than fixed income making the growth in her portfolio uneven. If after a year we meet with Reba and her portfolio is $1.6 million. Based on the optimal asset mix outlined in her IPS, 20 per cent, or $320,000, should be in fixed income. The remaining $1,280,000 should be in equities. When we looked at Reba’s portfolio, she had $283,000 in fixed income, and the remainder in equities. A disciplined approach would result in us selling $37,000 of equities and purchasing fixed income.

Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, however that is precisely what is required if the fundamental principle of “buy low, sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk. Rebalancing also helps smooth out volatility over time.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that has done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times, the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns.

Other forms of rebalancing

A more complicated component of the rebalancing process looks at geographic and sector exposure. Often at times, investors will have no clear benchmark at the beginning to assess the geographic and sector exposure. Without these parameters outlined at the beginning it is more challenging to have a discipline approach to rebalancing. Professional judgment and current conditions often move the benchmark of how funds are invested. Interest rates, political news, government policies and other factors can determine geographic and sector weightings.

Tax efficiency rebalancing

When a client opens up new accounts or makes significant deposits and withdrawals, this is an ideal time to look at all levels of rebalancing. Even with smaller deposits into an RRSP or TFSA account, it may be a good time to rebalance. In some situations, certain investments have better tax characteristics in different accounts. For example, we try to put interest-bearing investments and those that pay other income (such as foreign income) within an RRSP/RRIF. Investments that generate capital gains and obtain the dividend tax credit are often better situated within a non-registered account.

Managed accounts provide piece of mind

A managed account is a broad term that has been used in the financial-services industry to describe a certain type of investment account where a portfolio manager has the discretion to make changes to your portfolio without verbal confirmation.

There are different names and types of managed accounts which may be confusing for investors when looking at options between financial firms. To assist you in understanding the basics of managed accounts, we will divide the broad category into two subcategories — individually managed accounts and group managed accounts.

Both individually managed and group managed are fee-based type accounts, as opposed to transactional accounts, where commissions are charged on activity. Individually managed accounts must be fee-based and generally have a minimum asset balance of $250,000.

Before we get into the differences between individually managed and group managed accounts, we should also note that strict regulatory and education requirements are necessary for individuals in the financial-service industry to be able to offer managed accounts. The designation portfolio manager is typically awarded to individuals who are able to open managed accounts. Financial firms may also stipulate certain criteria prior to allowing their employees to provide discretionary advice or portfolio management services. Examples of additional criteria that may be required by financial institutions include a clean compliance record, minimum amount of assets being managed, good character, and significant experience in the industry.

For the purposes of this article, the term investment adviser is different from portfolio manager.

A portfolio manager may have the ability to offer individually managed accounts on a discretionary basis, whereas an investment adviser does not. An investment adviser must obtain verbal authorization for each trade that they are recommending. A client must provide approval by signing the appropriate forms in order for the portfolio manager to manage their accounts on a discretionary basis.

Above, we noted the two broad types of managed accounts — individual and group. A portfolio manager is able to offer both individual and group accounts on a discretionary basis. The individual account is a customized portfolio where the portfolio manager is selecting the investments. Although an investment adviser is not able to offer individually managed accounts, they can offer group managed accounts through a third party.

A simple example of this is a mutual fund which is run by a portfolio manager. A more complex example of this is the various wrap or customized managed accounts offered by third party managers. An investment adviser can recommend to their clients a third party group-managed account.

The role of an investment adviser in a group-managed account option is to pick the best third party manager and to assist you with your asset allocation. When looking at this option, you must weigh the associated costs over other alternatives. The group-managed account has set fees. With individually managed accounts, the portfolio manager has the ability to both customize the portfolio and the fee structure.

Trust is an essential component that must exist in your relationship to grant a portfolio manager the discretion to manage your accounts. Prior to any trades, the portfolio manager and investor create an Investment Policy Statement (IPS) to set the trade parameters for the investments. The IPS establishes an optimal asset mix and ranges to ensure that cash, fixed income, and equities are suitable for the investors risk tolerance and investment objectives.

Quicker Reaction Time: Having a managed account allows the portfolio manager to react quickly to market changes. If there is positive or negative news regarding a company, the portfolio manager can move clients in or out of a stock without having to contact each client individually. With markets being volatile this can help with reaction time. For an investment adviser to execute the movement in or out of a stock, it would involve contacting each client and obtaining verbal confirmation.

Strategic Adjustments: If a portfolio manager has numerous clients and would like to raise five per cent cash, this can be done very quickly with an individually managed account. It is more difficult for an investment adviser to do this quickly as verbal phone confirmation is required for each client in order to raise cash. Even with a group- managed account, an investment adviser would have to contact each client to change the asset mix weighting.

Rebalancing Holdings: With managed accounts, clients have unlimited trades. This is important as it allows a portfolio manager to increase or decrease a holding without being concerned about going over a certain trade count. As an example, we will use a stock that has increased by 30 per cent since the original purchase date. Trimming the position by selling 30 per cent is easy for a portfolio manager as a single block trade can be done. This block trade is then allocated to each household at the same price. If an investment adviser wanted to do this same transaction, it would likely take multiples days/weeks and over this period each client would have a different share price depending when the verbal confirmation was obtained.

Extended Holidays: If you are travelling around the world or going on a two month cruise, then you probably want someone keeping an active eye on your investments. An investment adviser is not able to make changes without first verbally confirming the details of those trades with you. A portfolio manager is able to make adjustments within the IPS parameters, provided you have a managed account set up before your departure.

Aging Clients: When our clients are aging, we often recommend that they introduce us to their family members and the people they trust. We encourage most of our clients to set up a Power of Attorney (POA) and to plan for potential incapacity later in life. Portfolio managers have a distinct advantage in this area as we can have a meeting with the family and document everything very clearly in an IPS. Having managed accounts, clearly documented IPS, and a POA will ensure that a portfolio manager can continue managing the investments appropriately.

Not Accessible: If you work in a remote area (mining or oil and gas industry), chances are you may be out of cell phone reach from time to time. In other situations, your profession does not easily allow you to answer phone calls (a surgeon in an operating room). In other cases, a lack of interest may result in you not wishing to be involved. A managed account may be the right option for clients that are frequently difficult to reach to ensure opportunities are not missed. In these situations, the portfolio manager can proactively react to changing market conditions.

Managed accounts greatly simplify the investing process for both you and the portfolio manager. It enables our clients to focus on aspects of their life that are most important to them while knowing that their finances are being taken care of.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.