Summary:
Rebalancing a mutual fund portfolio is a crucial strategy for maintaining the desired asset allocation and managing risk and is used by investors to ensure returns are maximised. This blog explains why you should periodically rebalance your mutual fund portfolio.
Introduction to mutual fund portfolio rebalancing
A mutual fund portfolio refers to a collection of different securities, such as bonds, stocks and other assets, that is held by a mutual fund on behalf of investors. Mutual funds are technically investment vehicles which pool money from investors and then use the funds to purchase a diverse portfolio of assets. Through this diversification, the risk can be spread, and investors gain access to a variety of investments without the need to purchase and monitor individual securities themselves.
The following are some of the key features of a mutual fund portfolio:
- Diversification: Mutual funds usually invest in a diverse mix of securities to help reduce the risks associated with investments in single or few assets.
- Professional management: The portfolios are managed by professional managers and investment teams who decide on which securities to purchase and sell within the fund. Their objective is to maximise returns and manage risks.
- Investment objectives: Mutual funds usually have fixed investment objectives, such as income generation and growth, or a combination of both. The composition of the portfolio depends on these objectives. For example, a bond mutual fund will primarily invest in bonds.
- Fund categories: There are different types of mutual funds, such as equity funds, money market funds, fixed-income funds, balanced funds, and sector-specific funds. For each, the focus is different, and the portfolio reflects it.
- Passive vs. active management: Mutual funds can be passively or actively managed. Passive funds are usually aimed and replicating the performance of a specific market index. Those which are actively managed aim to outperform the market through investments based on research and analysis.
- Fees and expenses: Investors who deal in mutual funds usually have to pay charges and fees, including management fees. These cover the cost of the management of the portfolio, as well as other operational costs. These fees vary from one fund to another and play a significant role in determining how investors balance their portfolios and choose their fund managers.
- Liquidity: Usually, mutual funds are liquid investments. This implies that investors can purchase or sell their shares on any trading day, at the fund's net asset value, which is calculated at the close of each business day.
The need for regular mutual fund portfolio rebalancing:
Rebalancing a mutual fund portfolio is a crucial strategy for maintaining the desired asset allocation and managing risk. Changes in market conditions, financial conditions, risk averseness, goals, objectives and government regulations have a massive impact on how mutual fund portfolios perform. To address this, investors need to rebalance their portfolios to ensure returns are maximised. The following are some of the main reasons why rebalancing mutual fund portfolios is imperative:
- Maintaining investment objectives: Over time, different asset classes' (bonds, stocks and cash) performance change, resulting in the deviation from the original objectives of the investment. Through rebalancing, investors ensure that the portfolio continues to be in line with their financial goals and risk tolerance.
- Risk management: Rebalancing is used to manage risk by keeping the portfolio from becoming too reliant on a single asset class that may have registered significant gains. By selling a few of the overperforming assets and purchasing underperforming ones, investors reduce the risk of the portfolio becoming overly exposed to volatility in the market.
- Control of portfolio risk: Asset classes have varying levels of risk; rebalancing enables investors to control the extent of risk of their portfolios. For example, if stocks appreciate significantly and make up a larger share of the portfolio than you initially planned, rebalancing helps bring the allocation back to the target risk level.
- Improve returns: Even though rebalancing doesn't guarantee that the returns will be better, it helps make the best of opportunities by purchasing assets when they are undervalued and selling them when they are overvalued. Following a consistent approach in this manner does improve the chances of returns in the long run.
- Discipline and avoiding emotional decisions: By rebalancing the portfolio as per a predetermined schedule and set of rules, emotional and impulsive investment decisions can be avoided. It ensures a systematic approach is used while maintaining the portfolio, instead of merely reacting to market fluctuations.
- Simplify portfolio management: As investments expand and evolve, portfolios become more complex. Through rebalancing, portfolio management is simplified to ensure it remains on course with the intended asset allocation.
- Adapting to changing objectives: With a change in financial goals, the desired asset allocation may also be altered. Rebalancing the portfolio helps adjust the portfolio to be in alignment with the changing objectives.
Summing up
Even though rebalancing is a crucial strategy, there are tax consequences because selling them triggers capital gains taxes. Consulting a financial advisor and/or a tax professional helps with informed decision-making for portfolio rebalancing based on the circumstances and goals of the individual investor. A clear strategy for when and how often to rebalance usually works wonders.