Rebalancing amid COVID-19 Turning Volatility into Opportunity

Rebalancing amid COVID-19: Turning Volatility into Opportunity

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Justin Henne, CFA

Managing Director, Investment Management and Strategy

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COVID-19 has investors questioning how they’ll react to ensuing market volatility. Rebalancing may provide an answer—but can investors overcome the associated challenges?

COVID-19 has reduced a vast majority of the population to home confinement over the past couple of months. As stay-at-home orders around the nation begin to relax and we move toward slowly assimilating back into everyday life in the outside world, it’s unclear how society will respond. Residual effects of social distancing may lead people to proceed with caution while we figure out what life will look like going into the era of a new normal.

The pandemic is having a similar effect on investors. Extreme market volatility has eroded their confidence and left many unsure how to move forward. Despite the uncertainty, most investors already have a plan in place to respond to such environments—a rebalancing framework defined in their investment policy statements. 

While it seems like a given that a responsive rebalancing program with well-defined thresholds should be applied in times of need, the implementation of this protective measure often gets overlooked and undervalued. The challenges surrounding implementation often lead investors to ignore, override, or modify their plans. This can cause investors to miss opportunities to add value to their portfolios—especially during periods of elevated market volatility.

Market volatility in 2020 

Before we explore rebalancing, let’s look closer at the market during the era of COVID-19. From its 2020 market high on February 19 to its market low on March 23, the S&P 500® Index dropped 33.8% in a mere 23 trading days. The market showed some resiliency in April, with the S&P 500® posting a 30.4% return over a period of 27 trading days.  

S&P 500® Index total return

S&P graph

Source: Bloomberg, 5/14/20.

The graph above indicates just how impactful COVID-19 has been on the equity market. A recovery can show market resiliency, but it can also leave room for uncertainty surrounding market stabilization. This uncertainty has made investors unsure how to respond. It’s precisely this type of market environment in which the discipline and responsiveness of an overlay rebalancing program can provide value.

Let’s examine the common challenges that investors face with rebalancing implementation, why it’s important during times of volatility, and how rebalancing through overlay programs can help investors forge a path forward amid the pandemic.

Implementation challenges faced by investors

Investors can add value to their portfolios by implementing rebalancing strategies, but a number of process challenges typically result in strong opposition—especially when market volatility is high. One challenge is the length of time it can take to identify and act on rebalance triggers. A lack of consolidated portfolio market values makes it difficult to know when rebalancing is required. In addition to enduring drawn-out decision-making and approval processes, investors run the risk of missing out on opportunities the market presents.

The steps following implementation approval tend to run out the clock on investors looking to react to market trends. This portion of the process can require a significant amount of coordination with multiple managers to buy and sell physical securities or funds. Undergoing the buy-sell gauntlet can become expensive and time consuming, and it may also result in missed opportunities.

The benefits of implementation

Despite the general apprehension investors have toward implementing portfolio rebalancing, there are many benefits when implementation is efficiently executed. One benefit is timely and efficient portfolio exposure reallocation. Rebalancing with an overlay program can be a cost-effective and efficient way for investors to achieve desired allocations in a reasonable amount of time.

Another benefit of implementation is minimizing exposure gaps during the rebalancing process. This protects investors from experiencing performance drag that may result from market movements during the movement of assets. Minimizing gaps in exposure may lead to increased returns and simplification of asset movements in a manner that saves time and money.

Proper implementation may also lead to the reduction of tracking error through policy-based exposure management. Placing emphasis on exposure management will help investors avoid deviation from policy targets that may increase tracking error. This factor becomes increasingly important in volatile markets.

Our overlay solutions seek to achieve the investor’s policy objectives.

How does an overlay help with rebalancing?

Implementing a rebalancing strategy through an overlay service gives investors access to daily portfolio monitoring, real-time rebalancing, and lower transaction costs. These benefits occur in addition to improving policy and benchmark tracking. Overlay managers that monitor investment portfolios daily are able to identify and respond to imbalances with agility. This gives investors the ability to target policy objectives instead of directing purchases and sales of individual holdings. When done correctly, rebalancing through an overlay program can help investors replace behavioral biases with disciplined buying and selling methods that can prove to be advantageous during times of high volatility.

Rebalancing through an overlay in the time of COVID-19

An example of the potential benefits of implementing a disciplined and responsive rebalancing program through an overlay can be seen in the following hypothetical table. The table compares a generic asset allocation that isn’t rebalanced during the first four months of 2020 with one that is rebalanced after exceeding the predefined rebalancing bands. The asset allocation consists of indexes that include 60% equity (comprising of 30% S&P 500®, 5% Russell 2000, and 25% MSCI EAFE) and 40% fixed income (Bloomberg Barclays Aggregate) assets. In this example, the rebalancing bands are set as a percentage (10%) of the target allocation. For example, with fixed income having a target allocation of 40%, the rebalance band for this asset class is plus or minus 4%—or 10% of the asset class (40%). 

Hypothetical results, January 1–April 30, 2020

Hypothetical Results Table

Hypothetical. For illustrative purposes only.

In the recent period of volatility, remaining true to asset allocation targets may provide meaningful return improvement over a portfolio that wasn’t rebalanced during the first four months of 2020. By rebalancing out of fixed income and into equity during the weak equity markets in March—and effectively reversing the trades after the April recovery—investors find the benefits of a disciplined and responsive rebalancing program are readily apparent. It’s important to note that capturing this rebalancing benefit didn’t require any market-timing skill. The portfolio gets mechanically rebalanced immediately after predefined thresholds are exceeded. This action removes emotion and biases from the rebalancing decision.

The bottom line

Market volatility can create a lot of upheaval and catch investors off guard because it’s hard to predict. By implementing a disciplined, rules-based portfolio rebalancing program, investors can be better prepared to react during volatile markets. This allows investors to keep portfolio exposures on target throughout turbulence—and volatility into opportunity.

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