Threshold Rebalancing – Hegde your RISK

Threshold Rebalancing is one of the most effective techniques to hedge risk. In layman terms, it is portfolio rebalancing. The key reason retail investors don’t make money in India is that they don’t rebalance the portfolio. There are two ways to rebalance the portfolio i.e. calendar rebalancing and threshold rebalancing. The concept of calendar rebalancing is similar to value investing. On the other hand, threshold rebalancing is linked to deviation from fixed target. Let me share a simple example. For simplicity purpose, i assume that my asset allocation is divided only between Equity and Debt Funds. If i have Rs 100 to invest and based on my age, my equity investment is Rs 60. Balance Rs 40 is invested in debt funds. In this case, the target for equity investment is 60%. In threshold rebalancing, all the calculations are in %. The absolute value does not have any relevance.

In the example mentioned above, i fix a threshold of 5% from fixed target. In short, i will not take any action till my equity investment of Rs 60 is between Rs 57 to Rs 63. Depending on risk appetite you may fix the threshold under threshold rebalancing at 10%. Similarly for debt funds, i set the same threshold of 5% i.e. the range of Rs 38 to Rs 42. For reference purpose, the investment amount is small i.e. Rs 100. Therefore, the range looks too narrow. Assuming an investment amount is Rs 10,00,000. In this case range for equity will be Rs 5,70,000 to Rs 6,30,000 i.e. 60k. Now i will sit back and relax till my equity, and debt investments are within range. Assuming, the market is not doing great & my equity investment hit the lower range i.e. 5% deviation from target. Now the worth of my equity investment is Rs 57. At this point assume the value of debt funds is Rs 41. At this stage total investment value is Rs 98. It’s time for threshold rebalancing. The target for equity is 60% of Rs 98 i.e.  Rs 58.8 and debt will be 40% i.e. Rs 39.2. Therefore, threshold rebalancing will force a shift of Rs 1.8 from debt to equity. It is similar to value investing i.e. invest more during a bearish trend. The only difference is that value investing is on stand-alone basis whereas threshold rebalancing is for the entire portfolio. To summarize, when any asset or financial product hit the threshold (Upper or Lower), you should swing into action.

Till now, threshold rebalancing looks great but it has its positives and negatives. Always remember that life is Zero sum game. If you are gaining something at the same time losing also. Usually, our mind is synched in such a way that we only see positives most of the times. As in the case of debt mutual funds, investors ignore hidden risks. The thumb rule of personal finance suggests that we should do a 360-degree evaluation. Let’s check Pros and Cons of threshold rebalancing.

Pros of Threshold Rebalancing

1. Risk Mitigation: All said and done & keeping all logics aside, the basic objective of threshold rebalancing is to hedge risk. Provided you have selected right asset class for the long-term, threshold rebalancing reduces risk considerably. Risk mitigation does not mean that you should stick to riskier assets. Sometimes the situation demands a complete exit from the particular asset class. Therefore, the judgmental power of an investor is at the test. Secondly, many investors ignore “Cash in Hand” for threshold rebalancing. In my opinion, it is also equally important as an investment, in particular, asset class. As i anticipated in my previous posts that Fed Rate Hike will crash Indian Bond market. Now, the experts are cautioning investors not openly but discreetly. My current strategy under threshold rebalancing is to shift from Equity and Debt to Arbitrage Mutual Funds & Cash in Hand.

2. Long Term Investment: To be honest, threshold rebalancing is only for long term investors. An investor can segregate the portfolio between long term and short term. The principle of threshold rebalancing should be used only for a long-term portfolio. The threshold/range for riskier investments should be narrow. On the other hand, safe investments should have a broad range.

3. DIY: If an investor is good in identifying right asset class/financial product then threshold rebalancing is a cake walk. You can manage your portfolio. You don’t need financial planners or investment advisers.

4. Peace of Mind: If an investor selects right products and right deviation from target then threshold rebalancing is more peaceful portfolio management. It holds true for stable markets. During volatile markets, it is a nightmare to manage the portfolio. Therefore, i trust arbitrage funds and cash in hand during volatile markets. By doing this also, i bought peace of mind :).

Cons of Threshold Rebalancing

1. Lower Returns: As i am not a financial planner or investment adviser, therefore, i don’t have vested interests :). I will give a clear and transparent picture. If you follow threshold rebalancing, then your returns will be lower than calendar rebalancing. The reason being, you will reduce holdings from performing asset classes to non-performing. It is based on the assumption that non-performing class will perform and available at a discount. If this basic assumption goes wrong like in the case of gold, then returns will be substantially lower.

2. Tax: An investor also needs to consider the tax implications of liquidating the investments. For example, if equity is doing too good and threshold rebalancing suggest to divert partial investment to debt funds. In this case, short term capital gain tax will be applicable on profits if investor liquidates before one year. Similarly, in the above example, if investor diverts from debt funds to equity before three years then also STCG will be applicable. In the case of debt funds, after three years long term capital gain tax will be applicable.

3. Exit Load: Normally, investors don’t check exit load of a mutual fund scheme. During volatile market or a narrow range, threshold rebalancing requires frequent portfolio churn. Therefore, you may check the exit load of the scheme before investment. Some schemes charge exit load as high as 3%. In short, exit load eat into your return. An actual return might not be as high as it is calculated by the investor.

4. Charges: Similar to exit load, you should also consider brokerage, stamp duty, taxes, other levies, commission, etc. These can be termed as entry/exit charges. Therefore, these charges also eat into the returns from investment. The profit/loss should be calculated net of these costs.

5. Illiquid Investments: Needless to say, the best example, is property. It is tough to buy or sell the property. It may take up to 6 to 12 months to close the deal. Therefore, managing threshold rebalancing for the property is impossible. Recently one of my clients wrote to me that he bought a flat for Rs 4,900/= psf on Dwarka Expressway in Delhi. Now he is finding difficult to dispose at Rs 3,500/= psf. You should be sure of property price before buying a property as it can destroy your personal finance planning.

Words of Wisdom: I shared both pros and cons of threshold rebalancing. An investor can take an informed decision. Selecting right financial products is important. Most importantly, you should not be emotional about your investments. Volatile times demand harsh and unpleasant decisions.

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