Mutual fund portfolio rebalancing - When and how to do it

Investing in mutual funds is now an integral part of most retail investors’ portfolios because mutual funds offer many benefits, ranging from professional management of funds and compounding returns to flexibility and convenience. You also have the benefit of choosing your mode of investing: lumpsum or Systematic Investment Plan (SIP). Another major advantage of mutual funds is the variety of options available—from equity funds to debt funds and everything in between.

However, simply investing once in mutual funds and then forgetting about it is not the most prudent approach. It’s essential to regularly review your mutual fund portfolio and rebalance it as required. What does this mean, and how to go about it? Let’s take a look.

What is mutual fund portfolio rebalancing?

There are several asset classes such as equity, debt, gold, real estate, and alternative investments. Equity and debt are the most common asset classes considered by investors, and each of these classes has a distinct risk-return profile that allows investors to achieve different financial goals and needs in different situations and times.

When you start investing in mutual funds, you may pick a certain asset allocation between equity and debt. You may invest 75% in equity mutual funds and 25% in debt mutual funds based on your goals, risk tolerance, and investment horizon. After some time, however, this allocation may change because of the investments’ performance and market conditions. Rebalancing your mutual fund portfolio means bringing back your mutual fund investments to that initial asset allocation proportion to ensure that they are in line with your financial goals and preferences. Fundamentally, it entails adjusting the weight or proportion of different asset classes in your mutual fund portfolio.

Hence, mutual fund portfolio rebalancing involves buying and selling different mutual fund scheme units periodically to bring your portfolio back to the desired asset allocation. Chances are that your financial goals and life situation, too, may have changed and, hence, you may now have a new ideal asset allocation for which you wish to rebalance your mutual fund portfolio.

Why is mutual fund portfolio rebalancing important?

When you decide a specific equity and debt mix for your portfolio, you may have considered three important factors—financial goals, risk appetite, and investment horizon.

Your financial goals include all your short-, medium-, and long-term goals, such as buying a car, funding your wedding, saving for retirement, and renovating your house. Your risk appetite is your ability and willingness to bear a certain amount of risk for the possibility of earning higher returns. It depends on your age, income, financial obligations, number of dependents, and personality type. Investment horizon is the period for which you will hold your investments. This depends on how far along you are in terms of achieving your financial goal and on the nature of the mutual fund.

These three factors are crucial for developing an effective mutual fund portfolio that maximizes returns and minimizes risks. Let us say you are an investor with a moderate risk appetite and are investing in mutual funds to achieve medium- and long-term goals with an investment horizon of 5–12 years. You may start off with an asset allocation that is 65% equity and 35% debt.

After a year, it is possible that because equity funds performed better, your equity allocation has grown to 80%, and in contrast, because debt funds performed poorly, your debt allocation has decreased to 20%. Now, this allocation mix carries a higher risk level than your ideal risk tolerance. For this reason, it’s essential to rebalance your mutual fund portfolio to reduce the equity allocation and increase the debt allocation to hedge risk.

When to rebalance your mutual fund portfolio?

Usually, it is prudent to review your portfolio after every six months or one year and rebalance it if required. Moreover, you should review and rebalance your portfolio after every major market or trigger event. Here are a few specific times when you should consider rebalancing your mutual fund portfolio:

• Overexposure to one asset class

In a bull market, your equity fund holdings would continue to grow in value relative to your debt fund allocation. You can decide for yourself the acceptable magnitude of deviation from your initial asset allocation such as +/-10%. If the allocation deviates beyond this magnitude, your mutual fund portfolio is overexposed to one asset class, which increases your risk level. In this case, it would be crucial to rebalance your portfolio and adjust your portfolio's exposure to each asset class.

• Consistent underperformance of a fund

It’s is important to regularly review your mutual fund portfolio to identify schemes that are underperforming consistently. Usually, if a mutual fund scheme has been underperforming for two to three years, you would do well to sell your units and invest the proceeds in another scheme. Notably, view the scheme’s performance in the context of the broader market. If the entire market has been down, then the scheme is only performing in line with the market conditions. However, if the market is performing well, and the scheme is underperforming its peer schemes, as well as its benchmark index, it would be wise to sell that investment and better utilize your funds.

• Change in financial situation

Changes in your personal financial situation may require a reassessment of your portfolio's asset allocation and, potentially, portfolio rebalancing. For example, if your income changes, because of a significant raise or job loss, you may want to adjust your asset allocation to reflect your new financial situation. Another example is if you receive a large cash inflow, such as an inheritance or bonus, or you need to withdraw a significant amount from your portfolio, it may be necessary to rebalance to maintain the desired asset allocation. For example, if you receive a large inheritance that causes your mutual fund portfolio to become overweighted in one asset class, you could rebalance it by investing some of the funds in other asset classes.

• Changes in fund’s fundamentals

When investing in any type of mutual fund, you should consider certain important factors, such as the fund’s asset allocation and holdings, fund manager, objective of the fund, expense ratio, mutual fund house’s management, and benchmark index. Over time, if there is a significant change in any of these fundamentals that could materially impact the performance of your mutual fund and overall portfolio, it may be prudent to sell the specific scheme. For instance, if a hybrid mutual fund initially had the investment objective of capital preservation, but over time, its holdings became highly concentrated in equity, and the risk level changed, you may want to sell off some of the units and reduce your exposure.

• Nearing retirement

Your ideal asset allocation naturally changes over time as you go through the different stages of life. When you’re in your 20s and 30s, your asset mix may have a higher proportion of equity and minimal debt. However, as you near retirement, this ratio is flipped because equity investments carry a higher amount of risk. Owing to market fluctuations, you could lose your capital. Hence, equity investments require a longer investment horizon to ensure that they have the time to recover from short-term market volatility. However, when you near retirement, your risk appetite decreases, and your investment horizon shrinks. For these reasons, capital preservation becomes more important—protecting the wealth you have already built instead of risking it to build more wealth. At a time like this, it’s crucial to rebalance your portfolio and systematically switch your holdings from equity mutual funds to debt mutual funds.

How to rebalance your mutual fund portfolio?

• Review your portfolio

The first step is to review your current mutual fund portfolio and identify which funds have moved away from your target asset allocation. You can do this by comparing your current mutual fund holdings across categories such as equity, debt, and hybrid to your original investment plan or target allocation.

• Determine your new target allocation

After you have identified the funds that need to be rebalanced, determine your new target asset allocation. This may require you to sell a few overperforming funds and invest in underperforming ones to bring your portfolio back in line with the desired asset allocation. This is important to hedge risk because even though the funds may be overperforming now, overexposure to one asset class may lead to massive losses when that asset class takes a hit.

• Decide a strategy

When rebalancing your mutual fund portfolio, you may use several strategies, such as selling and buying, making new investments, or automatic rebalancing. Choose a strategy that is the most suited to you and your investment goals.

• Execute the strategy

Typically, if you choose to sell and buy, you will need to sell overperforming funds and use the proceeds to buy underperforming funds. However, you can invest new money in the underperforming funds or in more funds of the asset class to which you want to increase your exposure. For instance, if you have a lumpsum investible amount, and currently, your equity exposure exceeds the target allocation, instead of selling your existing equity investments, you may use this amount to invest in debt funds, which would have the same effect of portfolio rebalancing.

• Monitor your portfolio

After rebalancing your portfolio, you should monitor it regularly to ensure that it remains consistent with your investment goals and risk appetite, which would help you to achieve your financial goals effectively.

Final words

Portfolio rebalancing is central to your financial health. Similar to how you may get regular health checkups done to take care of your physical health, you need to review and rebalance your mutual fund portfolio periodically.

You may consider consulting a financial planner or advisor if you are unsure of your ideal asset allocation or how to rebalance your mutual fund portfolio in a given market scenario. An expert may be able to help you make timely decisions that are strategic and help you achieve your goals without assuming excessive risk.

Either way, always ensure that your money invested such that your portfolio is aligned with your financial goals, risk appetite, and investment horizon. That’s the only way any of your mutual fund investments will turn out to be fruitful over the long term.

Source: Axismf Research

Note: Views and opinions contained herein are for information purposes only and should not be construed as investment advice/ recommendation to any party or solicitation to buy, sale or hold any security or to adopt any investment strategy. It does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The recipient should exercise due caution and/ or seek professional advice before making any decision or entering into any financial obligation based on information, statement or opinion which is expressed herein.

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