When is the Right Time to Rebalance your Mutual Fund Portfolio?

Mutual Fund advisors generally request to rebalance your portfolio one in a year. Does your mutual fund portfolio require a revision?

When was the last time you looked into your mutual fund portfolio? If you have a mutual fund portfolio, it is advisable that you make regular check-ups on a quarterly basis to ensure that it is performing as per your benchmarks. Your benchmarks are derived from your appetite for risk, financial goals, investment income and other factors. When you are aware of your benchmarks, you automatically look for the right allocation of debt-equity ratio.

But at times, due to market volatility or a stock plummet, you are required to rebalance your mutual fund portfolio in order to protect your investment.

Therefore, rebalancing can be defined as the process by which an investor makes alterations to their investment portfolio to its target allocation. If your mutual fund portfolio is not performing as per your expectations, you need to rebalance it to bring it back in line with your investment goals.

In case your mutual fund requires thorough revision, rebalancing is the only option. Rebalancing will help you bring back your portfolio to its original asset allocation. When you build a mutual fund portfolio, it is based on your appetite for risk and the investment amount. This indirectly reflects the debt-equity proportion within your mutual fund portfolio. Over the investment horizon, one asset class might move more than the other. Under such a scenario, the mutual fund portfolio has diverged from the original asset allocation. This, in return, will affect the overall performance of the fund.

Example, if equity stocks have been performing well over the last five years while debt bonds have been underperforming, the equity component of your portfolio will grow more than debt. This will increase the amount of equity in your portfolio if it was not originally intended. In such a case, you need to reduce the exposure to equity in order to restore the original asset allocation.

There are two important reasons why it is ideal to rebalance your mutual fund portfolio.

1. Suppose you have a portfolio made up to 60% equity, while the remainder 40% is in debt. This is your original asset allocation based on your risk appetite and timeframe. If your equity allocation goes up by 70%, you are taking in more risk than your initial asset allocation. Rebalancing your mutual fund portfolio will help in restoring the original allocation and keep the risk within tolerable limit.
2. Another important benefit of rebalancing is the ability to take advantage of a rising asset class and investing in a class with lesser value. This will ensure that you book profits in a preferred and timely manner. When the stock market performs well, the equity component will grow more handsomely in your portfolio in comparison to the debt component. When you rebalance, you would be actually booking profits in an asset class which has recovered (equity) and getting the same into an undervalue one (debt). Rebalancing is ideal when the equity-debt component is out of sync as this is a better option than trying to redeem an asset class based on market evaluation. You might just end up redeeming more than you gain.

The ideal time to rebalance your mutual fund portfolio is when you review the performance of the portfolio on an annual basis. If you feel that the original asset allocation has diverged by a certain parameter or percentage, it is ideal to rebalance it at that point. The minimum recommended divergence is 5%. Example, if you target equity allocation was 80% and the existing allocation is 60%, you must rebalance your portfolio. 5% is considered as the minimum threshold as it does not require frequent rebalancing and ensures that in times of market volatility, you can make rectifications for the same.

There are three ways to rebalance your portfolio:

• Redemption: This is the easiest method of portfolio rebalancing where you redeem the asset class which has grown out of proportion. Example, if you invest ₹60,000 in equity and ₹40,000 in debt, over a period of 5 years, the equity grew to become ₹1,50,000 while debt grows to ₹80,000. The new ratio of allocation is 65:35. In order to restore to the original asset allocation, you can simply redeem ₹30,000 from the equity portion. Although redemption is easy, it is not recommended as it will reduce the overall value of the fund. Also, if you redeem, what will you do with the ₹30,000? You cannot invest it again into equity as the price of equity has risen.
• New Investment: Under this option, you will be required to bring in fresh money to the asset class which has reduced in value. This will increase the value of the asset class and restore it back to the original allocation. This method comes with a similar drawback as mentioned in the previous method. Over the investment tenure, the value of the portfolio will be rising and so will the price of the components. Therefore, the amount needed to buy more components will be more. Only if you have surplus income, you can go ahead with this method.
• Switching: Under this method, you switch from the asset class which is disproportionately into the asset class which has reduced in value. While this method is suitable, at times, it may lead to an unfavourable asset allocation.

One important thing to remember is when you are putting more money into your mutual fund portfolio, ensure that the underperformance of the fund was due to market volatility rather than the underperformance of the fund itself. Underperformance of the fund due to non-market factors can indicate that the fund is not being managed properly. If that is the case, you need to let go of the fund and invest in a new one. This is where rebalancing can play a significant role.

Recommended Read: How to Choose the Right Hybrid Mutual Fund?