We believe investors should consider alternatives to rebalancing during times of extreme market volatility.
We explore the alternatives available to investors to help manage risk and potentially capture investment opportunities.
A disciplined rebalancing strategy is a common tenet of most strategic asset allocation policies. Often these strategies are calendar-based, range-based, or a combination of the two. At the end of a challenging and volatile first quarter, investors were considering alternatives to their standard rebalancing approach, given the magnitude of potential trades and the current challenges in the fixed-income markets.
With stocks off 15% during March, most investors were faced with a portfolio heavily tilted toward fixed income, requiring a significant sale of bonds and reallocation to stocks to bring portfolios in line with objectives.1 The estimates of this reallocation trade have ranged widely — from $190 billion to $900 billion of equities that would need to be purchased. Looking across the State Street custody business among asset owners, the differentials range from -3% to -10%, with the typical portfolio off between 5% to 8%.2 These levels are consistent with our multi-asset book as well. In some cases, investors who rebalance based on bands may have already done so earlier in the month. This earlier rebalancing, combined with the equity rally toward the end of March, would have reduced the ultimate size of required trading, but significant action still needed to take place. Given the additional challenge of fixed-income market liquidity, this raises questions for investors to consider in an otherwise straightforward execution.
There are several possible approaches investors can take as they consider their circumstances. Pushing ahead as scheduled is an option, but that may result in unsatisfactory trading costs. Other considerations include starting early, delaying, moving in tranches, creating a hybrid strategy that utilizes more liquid futures or ETFs, or tactical rebalancing.
Start early While this option has passed, as we’ve rolled past the end of the quarter, beginning early to phase trades helped to reduce market impact and trading costs. The dollar-cost averaging benefit also helped to smooth any single-day impact, given the wide swings recently seen in the markets.
Delay Another alternative was to delay and avoid what was likely to be the high volume at the end of March. Investors could then look to later in April, or even out to May, to execute and rebalance their portfolios. This strategy may have helped to avoid near-term transaction costs. However, there was the risk of opportunity cost if equities were to recover sharply, which would be especially true if the delay were pushed too far into the future. In these situations, we suggest monitoring market conditions and adjusting the targeted date as necessary.
Moving in tranches A partial rebalance option for some investors is to look across their portfolios and identify those investments that are more liquid and saleable, while deferring the rebalance of other, less-liquid segments to future points in time. By optimizing that mix into multiple tranches, it potentially alleviates some liquidity issues. It is also helpful to consider such indicators as macro events or improvements in trading costs, which will identify the appropriate time to invest in other asset classes.
Hybrid strategy For those investors who have access to overlay strategies, the use of futures and ETFs to adjust exposures can likely be an effective tool. In the current environment, shorting treasury futures would adjust the overall portfolio duration and fixed-income beta. The offset would be to invest in a basket of ETFs or equity futures, such that the portfolio’s overall stock/bond allocation is properly aligned to targets. As market conditions improve and liquidity returns, these positions would be unwound as final rebalance trades are executed in the cash market. This approach does raise potential basis risk, as exposure to spread duration remains. Still, as those markets are more difficult to trade at the moment, this delivers the targeted portfolio positioning.
Tactical rebalance Moving beyond a purely systematic rebalancing approach, those investors looking to implement a market view may want to adjust the pace and size of trades. Those more bearish could hold off on any rebalance that would translate to remaining underweight to equities. Alternatively, some investors see this as a buying opportunity and could fully rebalance, potentially adding to equity exposure, in order to take advantage of low valuations. A time horizon is essential in this decision, as the outcome is much more variable in the short term. For long-term investors, this could be a good entry point for either a simple rebalance or to increase overall equity allocations.
These are unprecedented times that call for investors to consider practical requirements to implement overall policy. Each investor’s situation is different, and the ability and willingness to deviate from the standard approach vary. Taking the time to consider the options available can help to mitigate risk and capture potential investment opportunities.
1 Bloomberg, MSCI World as of March 31, 2020. 2 State Street, as of March 20, 2020.
Diversification does not ensure a profit or guarantee against loss.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
The views expressed in this material are the views of the Investment Solutions team through the period ended 3/31/2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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