Bridging the Gap: A Tactical Rebalancing Act

tmb_bridgePortfolio rebalancing is the process of bringing a portfolio that has deviated from a target allocation back in line. The prevailing notion for much of the investment industry has been to set and then forget an investment portfolio and only rebalance on a regularly scheduled basis, either monthly quarterly or in some cases yearly. Despite the fact that this has long been the industry standard, in the current low-return environment, this “set it and forget it,” autopilot strategy simply is not good enough. Markets do not follow a calendar and neither should investment decision-making.

By rebalancing a portfolio opportunistically, investors are able to harness the true power of tactical rebalancing and capture mispriced opportunities along the way to boost returns without increasing risk. This is an important and often overlooked step to bridging the gap between what is possible and what is required from an investment portfolio in today’s environment.

However, it is important to distinguish between tactical rebalancing and market timing. When engaging in tactical rebalancing, investors should employ a disciplined and repeatable process. In our view, the first step is to group asset classes by a common risk metric and volatility. By grouping assets in this way, what we at Balentine refer to as our “Building Blocks,” it is easier to identify predictable cycles in asset class relative performance. These cycles often occur with large amplitude and take longer to unfold than a month, quarter or even a year. It is also possible to analyze how cheap or expensive asset classes are relative to one another (relative value) and to determine whether these mispricings are being recognized (momentum) to exploit these cycles.

This discipline is not market timing. When we make rebalancing decisions, our goal is to hold these positions for a year or more. On average, it leads to about half a dozen shifts a year. It is not a hyperactive effort to get in and out of the market based on its every twist and turn. It is like a tightrope walker taking measured steps to get to the destination.

This year, we have had significant market exposure as markets have climbed a wall of worry about Europe and the fiscal cliff. One of the ways we have used tactical rebalancing to enhance returns within Market Risk is by positioning portfolios in a contrary way where an investor is more likely to be paid for taking risk. For example, as we explained in “Increased Stability Opens Door for European Opportunity,” after having no direct exposure to European equities for nearly two years, Balentine reduced exposure to US equities and reestablished a position in European equities. By investing in European equities, we felt we were being paid to participate in any further upward momentum in equity markets while still having a margin of safety if markets were to correct from those levels.

Though often overlooked, when used as part of a disciplined, repeatable process, tactical rebalancing can add significant value to investment portfolios. Balentine is not a “set it and forget it” auto-pilot firm. Instead, we believe dynamic tactical rebalancing is a powerful tool to add value in a low return environment.

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