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A portfolio can be rebalanced by either selling a portion of the outperforming asset class or by buying more of the underperforming asset class.
The beginning of a financial year is an ideal time to conduct the annual portfolio review. If you have a financial advisor, schedule a meeting with her. For those who don't, here's a detailed road map.
Equity market surge
Midcap and smallcap funds have surpassed their largecap peers over the past year.
Debt funds have performed reasonably well in a high interest rate scenario.
Gold exchange-traded funds (ETFs) have on average turned in double digit return.
Many investors may find that their portfolios have become overweight on equities, especially on midcap and smallcap funds. This skew must be corrected through rebalancing.
Why and how to rebalance
Many investors want to let the winners within their portfolios run so that they can make the most of the ongoing bull run. Doing so is fraught with risks.
Take an example. Suppose an investor originally had a portfolio with 50 per cent equities and 50 per cent debt, and has not rebalanced it for a long time.
The equity portion is now 75 per cent of the portfolio and debt is 25 per cent. The equity market crashes by 20 per cent.
If she had a 50 per cent allocation to equities, this portion would have suffered a 10 per cent drawdown. But since equities now comprise 75 per cent, it suffers a 15 per cent drawdown.
Thus, risk rises with increased equity allocation.
"The original asset allocation would have been set based on your risk appetite. If you allow equity allocation to increase, your portfolio's risk profile may increase beyond your tolerance level," says Deepesh Raghaw, a Sebi registered investment advisor.
Two, to make profits, investors need to buy low and sell high, a psychologically difficult task for most.
Rebalancing forces investors to sell an outperforming asset class (midcap and smallcap funds this year) and buy (relatively) underperforming asset classes (fixed income and gold).
This rule-based approach enables them to buy low and sell high.
A portfolio can be rebalanced by either selling a portion of the outperforming asset class or by buying more of the underperforming asset class.
Experts increasingly suggest buying more of underperforming asset classes.
This year, for instance, investors could rebalance by directing future systematic investment plans (SIPs) into fixed income and gold until their portfolio returns to the original allocation.
"When you sell an asset class, it could give rise to tax incidence. Investors must try to delay triggering taxation for as long as possible," says Avinash Luthria, a Sebi-RIA and founder, Fiduciaries.
However, this approach may not be feasible if you are close to a goal. For instance, your son's college education may be just three years away.
"In that scenario, you would have no alternative but to book profits in equities and move the money to debt so that market volatility does not affect your goal," says Ravi Saraogi, co-founder, Samasthiti Advisors.
Normally, investors should sell sub-assets proportionately (sell largecap, midcap, and smallcap funds according to their weights).
"In extreme scenarios -- like the steep run-up in midcap and smallcap funds over the past year -- it is okay to sell more of the outperforming sub-asset classes," says Saraogi.
Raghaw suggests that investors can also avoid taxation by rebalancing within the National Pension System (NPS) as it offers tax-free rebalancing.
This option, however, is open only to investors with substantial NPS portfolios.
Debt fund dilemma
With debt mutual funds becoming taxable at slab rates, many investors, especially those in the higher tax brackets, have become reluctant to invest in them as their post-tax returns would not be attractive.
"Investing in arbitrage funds, which receive equity tax treatment, partially addresses this issue," says Luthria.
Many investors are keen to go for hybrid funds. "If you opt for a hybrid fund, understand its asset allocation and its tax treatment. Individual funds within the same category could have varied tax treatments," says Raghaw.
Also understand the impact of including these funds on your overall asset allocation.
The limits on investing in international fund-of-fund and ETFs may also make it difficult to adhere to your asset allocation.
One option is to keep hopping from the fund that closes down to one that is still open.
"Another option is to take the Liberalised Remittance Scheme (LRS) route," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Other essential checks
Ensure that you have faithfully implemented all the tasks your advisor had set during the previous review.
"Check whether you ran all the SIPs or fell short. If the advisor suggested opening a Public Provident Fund account, purchasing a health or term plan, or building an emergency corpus, make sure you carried out these tasks," says Saraogi.
Get your advisor to periodically carry out a risk assessment, as your risk profile, too, could change over time (due to your life stage, job loss, state of the market, etc).
Finally, during the review try to simplify your portfolio by reducing the number of funds.
Disclaimer: This article is meant for information purposes only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article to influence the opinion or behaviour of the investors/recipients.
Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
Feature Presentation: Ashish Narsale/Rediff.com
