The Rebalancing Requirement
Rebalancing improves risk-adjusted returns — But a simplistic approach fails in today’s market — Allocators must simultaneously rebalance, diversify, and restore liquidity.
PRIVATE EQUITY OWNS THE BANK
Rebalancing investment portfolios has been shown to reduce portfolio risk and volatility, ultimately providing better risk-adjusted returns. According to Morningstar, “Rebalancing…is one of the best ways to protect against market movements altering a portfolio’s risk profile.”
The current market environment creates a unique challenge for allocators looking to rebalance their portfolios and mitigate risk. Historically, rebalancing between stocks and bonds may have provided protection, but more thoughtful rebalancing is required today.
Private, Illiquid Investments
Private market investments have been widely adopted over the past decade. Allocators have benefited from the strong returns of private markets but now face the issue of illiquidity. The combination of slowing capital distributions and preexisting capital commitments limits an allocator’s ability to rebalance away from these investments.
In an environment of high multiples, rising interest rates, and slowing distributions, it could be wise to rebalance away from private investments, but without liquidity this tool is not available to allocators.
Public, Non-Diversified Assets
Public markets offer plentiful liquidity for rebalancing, but here allocators face another challenge. The Magnificent 7 are now approaching 35% of the S&P 500. What was previously a diversified index now has a substantial weight that is increasingly correlated with the future of AI adoption.
As an example, simply rebalancing to a 60/40 portfolio, presumably selling equities and buying bonds to return to this standard weighting, leaves an investor with 35% of their equity portfolio, and over 20% of their total portfolio, in seven highly correlated businesses.
The purpose of rebalancing is to reduce portfolio risk and, in today’s unique environment, simply reducing index exposure is not enough.
What To Do With Bonds
Given the strong performance of equity markets over the past few years, most allocators would be rebalancing out of equities and into bonds. With the US 10-year Treasury offering a nearly 5% yield, this rebalancing looks prudent.
But allocators taking this simplistic rebalancing approach have a key risk in their portfolios. In the event of stagflation, interest rates could remain elevated or even increase further, pressuring the bond portfolio at the same time equities fall.
The US Federal Reserve appears to be taking a strong stance toward containing inflation and may not be poised to rescue equity markets in a downturn if inflation continues ahead of its target.
Thoughtful Rebalancing
Most investors have benefited from the long-term bull market and are in the fortunate position to have substantial investment gains. These gains, combined with the rebalancing issues laid out above, present allocators with a dilemma. Simplistic equity/bond rebalancing is not enough. Allocators would be prudent to not only rebalance, but also re-diversify.
Target weights of private holdings should be reconsidered with liquidity in mind. Allocators must “look through” their passive holdings to understand their level of diversification, or lack thereof, in their public equity books. Bonds may not be the obvious answer to rebalance toward in our inflationary environment.
Back To The Future
The solutions to many of today’s allocation challenges buck conventional wisdom. Liquid investments are likely to show their true worth in the coming years; liquidity, after all, is required to take advantage of market dislocations. Actively managed public equity funds could once again outperform their passive competitors, particularly where managers have avoided the concentration of the Magnificent 7. And underappreciated, under-owned, liquid assets may once again provide their investors with not only alpha but diversification at just the right time.
Source: Morningstar (https://www.morningstar.com/funds/heres-why-you-should-rebalance)
