Should you rebalance your assets?

Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” This is an apt quote for the current market conditions, which continue to cause investors indigestion. Whether you want to call this Credit Crisis II or a continuation of that of 2008, the fact remains that equity markets have fallen substantially in the past two months, and many investors are offside their selected investment strategy. So, again, we are having to ask the question of whether or not to rebalance.

In March 2009, Watson Wyatt (now Towers Watson) wrote:

Our core advice at this time is not to rebalance without a review of the suitability of existing strategic asset allocation policy. In particular, we think that the economic, capital market and political environment is now very different from that which prevailed when many pension plans set their current strategic benchmarks.

Rebalancing is a process for keeping asset exposure to an agreed target benchmark, and is beneficial as it limits the potential to diverge substantially from the benchmark. Rebalancing does not, however, reduce risk in an absolute sense or relative to a liability-related benchmark. It definitely does not reduce extreme event risk—as risky assets fall in value, rebalancing involves buying more risky assets, thereby increasing losses if assets continue to decline in value. Some have called this “catching a falling knife.”

So back to the central question, whether or not to rebalance. Towers Watson’s considerations in 2009 are outlined in the next few paragraphs. The key question is whether they remain relevant.

Our main concern is rebalancing into riskier assets when a strategic review might lower their allocation. There are a number of factors that suggest a lower allocation to risky assets might be appropriate in the strategic benchmark going forward, particularly for those funds with frozen or limited future benefit accruals:
  • A significantly elevated level of uncertainty in the economy and capital markets. This makes judgments about taking risk harder and creates some preference for avoiding risk;
  • A significantly higher level of mark to market volatility. This makes risk per unit of capital invested higher; and
  • Potentially higher expected returns per unit of capital invested. This means lower allocations to risky assets are needed to achieve a given return level.

Offsetting this are reasons why the same or higher level of risky assets might be appropriate:

  • A view that risky assets might be considered “cheap” and offer higher returns per unit of risk than when the last review was taken; and
  • Increased deficits might require higher returns going forward.

We find the “cheap” argument difficult to agree with currently given the macro headwinds created by the systematic deleveraging process.

It is difficult to disagree that many of these considerations remain relevant today, where deleveraging continues, concern for a return to recession remains a very real possibility, market volatility continues to be elevated and potential sovereign debt default and macro concerns predominate. Returning to Towers Watson’s March 2009 article, the advice regarding rebalancing was as follows:

Our view is that funds should review their strategic policy before rebalancing. In addition, we see a number of reasons why some funds might prefer to have lower allocations to risky assets in the short term than their strategic allocation suggests. However all investors need to weight their beliefs about long-term investment against their ability to adapt their thinking as circumstances change. This might cause some investors to rebalance in part while they review their strategic allocation.

In fact, some funds have ranges within which they do not rebalance. For those funds where the ranges are relatively tight, the debate should centre around rebalancing in part, not at all or fully. For those with wide ranges, rebalancing around the bottom of these ranges might be appropriate.

In 2008 and 2009, Towers Watson had a number of clients who elected to suspend rebalancing in part or in full. In the current environment, each plan sponsor will determine its course of action as appropriate. Whatever the decision, it needs to be clearly documented along with the rationale for that action. Where rebalancing has been suspended, or only implemented in part, documentation should include what events and triggers would cause it to be reactivated or implemented in full. Most importantly, plan sponsors should re-examine their attitude toward risk, as the current market and economic turmoil show no signs of abating.