Key Points:

- Over a 5 year period, the portfolio approach enabled investors to avoid the drawdowns of its worst-performing constituents
- Over the 5 years, the portfolio approach generally keeps pace with the second-best performer
- Portfolio maintenance via rebalancing is important to maintain the target risk exposure
- Rebalancing does not have a significant effect on returns over a 5-year period, but over decades, can contribute positively to a portfolio’s performance

Previously, I walked you through the example of a portfolio worth S$4,000 consisting of four funds.

Rather conveniently, I left out the all important question that keeps gamblers, traders, investors, and business owners up at night: Will it profit?

In the future, no one knows, because markets are unpredictable and the best we can do is make a reasonable guess.

In the past, however, we can gain some clues about how the portfolio would have performed over a 5-year period, and including the recent volatility of 2011.

Clues From Historical Performance

As usual, historical returns are no indication of future returns. The purpose of this section then, is to see how the simple portfolio performs over the past 5 years, and make some observations so we have a vague idea of what to expect from the portfolio.

Chart 1 shows the simple portfolio and its constituent funds. Our historical period spans from end-2005 till end-September 2011.

Note that for purpose of comparison, I’ve substituted the FTIF-Templeton Glb Bond A(mdis) SGD-H1 with the fund’s USD share class, which we do not currently distribute. This was done to expand the available data, as the SGD-hedged class was only incepted in 2008. The USD share class is a viable substitute, as the FTIF-Templeton Glb Bond A(mdis) SGD-H1 runs the same strategy, but with an SGD-hedge, such that you get the returns of the USD class, but in SGD terms.

Looking at chart 1, we can make several observations. Firstly, the simple portfolio tends to outperform the worst performing constituents and over the entire historical period, the simple portfolio has kept pace with the second-best performer, Aberdeen Global Emerging Markets.

Not too bad a result, especially in 2008, where the portfolio approach enabled us to outperform the worst-performing constituents. Table 1 displays the yearly performances of the four constituents, and the portfolio.

From Table 1, we can observe the effectiveness of diversification in a portfolio when, in 2008, the portfolio fell -21.26%, a far cry from the -44.23% drawdown experienced by the worst performer in the portfolio, Aberdeen Global Emerging Markets. Conversely, in 2009, when the same fund was the top performer, it helped raise the overall portfolio’s performance, such that the overall performance beat the second-best performing constituent, PRU Mthly Income Plan Cl A by a significant 5pp margin.

Even in the recent volatility of 2011, the portfolio returned -9.22%, which is a fair return, considering the bloodbath of 3Q2011 sending the FSMI All Equity index down -17.4% year-to-date, as at 30 September 2011. In fact if you read our Research team’s excellent summary on markets at 3Q2011, you’ll see the portfolio outperformed the large majority of equity markets, thanks to its diversification into bond funds and fund selection.

We can now go into the third and final feature – portfolio maintenance.

Key feature #3: Portfolio Maintenance

For those of you who have been using the portfolio approach for some time, you probably know the concept I’m about to talk about – rebalancing.

Rebalancing is the strategy of taking profit on your winning positions and adding to your losing positions. The benefits of rebalancing are twofold. Firstly, it forces investors into a disciplined routine, which helps manage emotions when investing. Emotions cloud logic, and if you lose control of your emotions, chances are your judgment goes out the window too.

For the purposes of investing, the two dominant emotions to be avoided are greed and fear. Greed causes you to hold a winning position past the peak and down the trough, while fear holds you back from taking advantage of investment opportunities in the market. Both emotions eventually lead to poor investment decisions, which can wreck years of profits.

The second benefit is the prevention of portfolio “style drift”. Typically, style drift refers to the divergence of a portfolio from its initially stated investment objective or investment style (source: Investopedia). For instance, a manager who calls his strategy ‘buy-and-hold’, but starts flipping penny stocks, is guilty of style drift. For the purposes of this article, I’ll borrow the term and define style-drift as a deviation from our portfolio’s initially stated allocation or objective.

Remember our example portfolio in part one of this series, I set out the investment objective as “a globally-diversified portfolio of four funds”. Assuming no rebalancing, imagine equities were to embark on a 5-year bull run, while bonds went on a 5-year bear market, the portfolio would no longer be diversified across assets, as I would be heavily overweight equities relative to bonds. The danger is you may end up with a portfolio that you had no intention of holding, hence being invested in a strategy that doesn’t suit your risk profile/appetite.

One common misunderstanding is that rebalancing will maximise returns. This is not always the case. Market conditions play a big part in determining the impact rebalancing (or any strategy for that matter) has on your overall portfolio returns. In a volatile market, when markets can swing wildly from one extreme to another, rebalancing will help maintain the allocations in your portfolio. During a bull market, a buy-and-hold strategy is more profitable than rebalancing, as you stay invested and participate in the uptrend longer. During bear markets, however, a buy-and-hold strategy is a lot like a vacuum cleaner – it sucks.

The reality of investing life is no one can predict which market conditions will prevail over time – which is precisely why one needs strategies such as diversification, asset allocation and rebalancing to prevent volatile markets from pulling one’s portfolio off its predetermined course.

So here’s how it’s done.

Calendar Rebalancing: How it’s done, step-by-step

Firstly we need to determine how frequently to rebalance. While there’s no hard and fast rule for how to rebalance, and how often, we’ve found that annual rebalancing generally works well for portfolios.
Returning to our simple portfolio example, our target allocation is set at 25% per fund.

This means every year, we bring our entire portfolio’s value, and distribute it evenly among our four funds. To figure out how much to buy or sell out of each fund, we’ll need the following additional pieces of information: latest total portfolio value, and latest individual constituent fund value.
I’ve made up some imaginary values to help illustrate how it works, as shown in Table 2.1.

Next, calculate the target individual constituent fund value, by multiplying the latest total portfolio value by the target allocation of each fund, as shown in Table 2.2.

Our last step is to determine what actions to take for each fund, in order to return it to the target allocation. Subtract latest value from target value to determine what actions need to be done, as shown in table 2.3.

And there you have it, a step-by-step guide to rebalancing. But how does this affect returns? Well, it depends on your holding period. Turning again to the end-2005 to end-3Q 2011 period we examined, I compared the simple portfolio with rebalancing versus without rebalancing. The information is shown in Table 3.

Clearly, the difference between the two portfolios is remarkably small. As mentioned, rebalancing is largely a matter of instilling discipline and maintaining the portfolio’s target allocation. Over decades however, the positive value of rebalancing has been documented yearly on Fundsupermart.

And there you have it. A globally diversified portfolio of 4 carefully-selected funds and rebalanced yearly. There’s little else to be said on the topic for now, so just few final thoughts to wrap things up.

Final thoughts
To start off, the portfolio we constructed is just an example. You could put together any number of portfolios using the same three features mentioned in these two articles.

For example, you could build your own balanced Singapore portfolio, with equity and bond funds focused in Singapore. You could build a diversified dividend portfolio of good dividend yielding funds that span equity, bonds, and perhaps even property. You could build a short-term cash holding portfolio, to diversify your cash holdings from bank accounts. I know of an acquaintance who keeps his cash holding in banks at a strict limit so their telemarketers never call him with offers of credit cards and loans.

Perhaps the next logical step is to ask, what should I do once I have more than S$4,000 to invest? It’s really up to you. You could just reinvest it into the simple portfolio.

Or you could seek greater diversification by exposing yourself to assets beyond equities and bonds. One asset class is commodities, which tend to appreciate with inflation. Resource funds, commodity funds, gold and gold equity funds fall under this category.

Or you could start a supplementary portfolio, seeking to capitalise on sectors and single countries that may be mispriced by the market, and are showing value.

Alternatively, you could look in the alternative asset space if you have the means to invest in it. Retail investors have a limited selection of alternative funds, and one such fund is Man AHL Trend SGD. Investors who find themselves with the happy problem of having an abundance of resources, and a scarcity of investment options, are welcome to get in touch with us and ask about the Fundsupermart Platinum Club.

For now though, gentle reader of limited means, the more important priority is to establish a strong foundation by building a globally diversified portfolio of quality funds.

If you have any comments, questions or complaints about the article, feel free to drop a feedback post in our forum, or email me: nicholastay@fundsupermart.com