Portfolio review and asset allocation are critical during heightened market volatility. And there are lessons to be learnt from how fund managers handle similar challenges.

The last few months have seen investors question their investment strategies and seek their financial adviser’s council on the extent to which their portfolio may need rebalancing. In some cases, their goals or financial circumstances may have changed due to the COVID-19 pandemic but, for other clients, it is their risk tolerance that is being tested.

Ryan Felsman, Senior Economist at CommSec says portfolio review is critical during heightened market volatility so that both client and adviser can ‘stay the course’. This is done by identifying sectoral and cash allocation targets and timing the market, particularly if there has been a significant drawdown.

“The balance of client’s investments will have likely moved in recent months with some asset classes performing better than others, especially with the rebound in shares since the March lows,” he says. “Therefore, rebalancing may mean that advisers return their client’s portfolio back to the ‘agreed’ investment ratios or target asset allocations, determined during the initial portfolio design phase.”

The goal for advisers should be to continually encourage and assist their clients with the rebalancing of their portfolios by re-aligning their target asset allocations as these change over time. Generally, a well-diversified portfolio should be rebalanced semi-annually or at least annually depending on whether the client is in the accumulation or retirement phase. 

“One of the potential upsides of a disciplined rebalancing process is that advisers can ‘lock in’ profits for their clients,” Felsman says. “And advisers can reinvest the proceeds into other asset classes – gaining advantages from portfolio diversification – through higher returns while mitigating volatility and downside risks to the portfolio. A failure to periodically rebalance could leave clients over exposed to one or two asset classes, increasing concentration risk.”

However, advisers must ensure clients remain well aware that a disciplined rebalancing process can incur some costs. Some investments – especially unit trusts – incur entry and exit fees and commission charges. Clients may also be subject to capital gains tax when investments are sold.

Tips from the top

Like professional fund managers, financial advisers are always looking to help their clients to both establish an investment strategy and periodically rebalance their portfolios in a non-emotional, cost-effective and impartial way. So what lessons can be learnt from professional portfolio managers? 

“Fund managers constantly monitor the holdings of their client’s portfolio through a disciplined investment process and relentless focus on dynamic asset allocation, tactical stock and sector selection, as well as portfolio rebalancing,” Felsman says.

“While positioning and allocations are often determined by the risk and benchmark parameters agreed in the client’s mandate, managers are also required to undertake a regular client portfolio review – often on a quarterly, semi-annual and/or annual basis.”

During these reviews, the client and asset consultant will usually assess the efficacy of tactical asset allocation decisions, stock and sector selection, the market timing and implementation of investment decisions, risk objectives and the regularity of portfolio rebalancing.

Felsman recommends financial advisers adopt a similar strategy with clients in all types of markets, while prioritising risk relative to asset allocation and portfolio returns. However, this can be easier said than done, especially during periods of prolonged and heightened market volatility.

“The best way to counter these concerns is for advisers to reassure their clients that they already had an investment plan in place to counter unforeseen economic events and changes in their personal circumstances,” he says. “While periods of short-term volatility are unnerving for all clients, they are investing for the long-term.”

While asset allocation and portfolio rebalancing are key, Felsman argues that the former is arguably the most important decision in the portfolio construction process. To address this, the financial adviser must take into account the client’s risk tolerance, time horizon and financial goals.  

“Over time – and especially in a volatile market – a portfolio’s investments will likely ‘drift’ from the target asset allocation,” he says. “Therefore, the portfolio’s risk and return characteristics may become inconsistent with the previously agreed financial goals and objectives of the client. By rebalancing their client’s portfolios periodically, advisers can reduce ‘portfolio drift’ and exposure to risk relative to target asset allocation.” 

Alternatively, financial advisers can look to rebalance their client’s portfolio any time an allocation ‘drifts’ over a certain agreed upon threshold, such as five per cent. 

Diversification

Felsman says the critical ingredients for an investor’s long-term financial plan in the current market environment are: having sufficient liquidity, allocating strategically, being adequately diversified across asset classes and considering tax loss re-harvesting.

“Allocating a client’s portfolio across several asset classes can potentially mitigate risk with some investments rising and others falling during episodes of heightened market stress,” he says. 

“Like professional investment managers, financial advisers should diversify their client’s investments across a range of asset classes, including styles (i.e. growth and value), sectors/industries and geographies.”

Shares (both local and international) often provide an opportunity for higher growth over the longer term, while at the other end of the risk spectrum; bonds can provide interest, income and a more defensive posture for more conservative clients. But within these two major asset classes, some sectors or instruments are more volatile than others. 

“For example, high-yield corporate bonds offer higher yields, but are inherently more risky with default risk mostly higher than ‘risk-free’ government debt,” says Felsman. “And some clients prefer the ‘safety’ of cash through money market funds and certificates of deposits.”

Others may prefer to free up liquidity – through cash holdings – to eventually ‘put to work’ in other asset classes when opportunities present during periods of market dislocation. Commodities, listed property trusts and alternative investments (i.e. infrastructure) are also areas where advisers can allocate client money.