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For many people, one of the biggest attractions of investing in exchange-traded funds (ETFs) is their low maintenance. It's fairly easy to construct a well-diversified, low-cost portfolio. Then you can just forget about it, right? Not quite. The reality is a bit different. It's important, experts say, to rebalance your ETF portfolio – and do it the right way.
Daniel Straus, an ETF and financial products analyst at National Bank Financial in Toronto, says there are two main reasons investors should regularly rebalance their ETF holdings.
The first reason is risk drift. Mr. Straus uses the example of an investor who has determined that a 60/40 bond/stock portfolio is best aligned with his or her risk tolerance. At a time like this, when stocks have been hitting record highs, and the value of equity ETFs has been rising, the investor might find that the portfolio has become 50/50 bonds/stocks, or even more heavily tilted toward equities. Without rebalancing, this investor would then be facing more market risk than he or she would otherwise be comfortable with.
The second reason is discipline. "One of the worst behavioural pitfalls in investing is buying high and selling low," says Mr. Straus. He notes this is a natural outcome of the tendency for people to want to buy the best performing assets after a lot of their positive returns have already played out.
Rebalancing automatically forces them to do the opposite. If investors rebalance their asset allocation regularly and with discipline, they will automatically find themselves selling past winners and buying relative underperformers in order to bring the whole weighting scheme back in line. Mr. Straus notes this locks in gains and gives poor-performing assets a chance to recoup their losses.
When it comes to how to rebalance your ETF portfolio, Mr. Straus says the key is to do it with discipline: not too frequently and not too rarely. "Discipline means having impassive, fixed rules about how and when to rebalance," he says.
Some investors use triggers, such as an asset class drifting more than 5 per cent away from their portfolio guideline. Others rebalance every quarter or six months. "In our experience quarterly rebalancing is perfectly frequent, and even annual rebalancing works well," says Mr. Straus. "Monthly rebalancing might be overkill, and daily rebalancing is almost certainly too frequent."
He notes trading costs and commissions become a factor with too-frequent rebalancing.
And to state what might be obvious, the rebalancing is accomplished by selling units of the ETFs that have become overweighted, and buying units of those that have become underweighted.
Stan Wong is also an advocate of the value of ETFs in most portfolios, and also stresses the need to rebalance. The director and portfolio manager at Scotia Wealth Management in Toronto says investors should rebalance their equity and fixed-income allocations from time to time to reflect current objectives and risk tolerances.
In addition to watching asset-class levels, Mr. Wong also recommends investors take a tactical approach to rebalancing ETF holdings – especially when it comes to funds that focus on a certain sector of the market, or geographic region. "If the outlook for a particular sector or style of ETF falls out of favour, investors should act accordingly," he says.
As a corollary to that approach, Mr. Wong notes that since the U.S. election, there has been a significant rotation from perceived "safe assets" (such as defensive equities, government bonds and gold) to "risk-on" assets, or assets that tend to be bought during lower-risk markets, (cyclical equities, high-yield bonds and energy and base metal commodities), as new U.S. President Donald Trump indicates a pro-business stance, and introduces measures to stimulate the economy.
He expects this trend to continue over the medium term, so is recommending certain ETFs focused on specific sectors such as financials, industrials and materials. He also notes value stocks are outperforming growth stocks in the current environment so he recommends ETFs that focus on value investing.
John De Goey, portfolio manager at Industrial Alliance Securities in Toronto, is also a fan of ETF investing. He says ETFs work well for people who want diversification but refuse to "pay extra" for stock picking strategies used by most mutual funds.
His approach is to draw up an investment policy statement for each of his clients. That statement includes the percentage of fixed income that makes sense for the investor, then equal-weights the rest between five asset classes: Canadian equity, U.S. equity, international equity, emerging market equity and tangibles/alternatives (such as commodities and real estate).
When it comes to rebalancing, Mr. De Goey says the best time is "when there is money in motion."
For people currently in their earning years that usually means when they are allocating new funds to their investments. Retirees are commonly drawing down their nest egg, so the rebalancing may be addressed when withdrawals are made.
Unlike Mr. Wong, Mr. De Goey does not recommend changing allocations based on current market trends.
"If your investment policy statement is worth anything, it is worth sticking to," he says. "Timing the market and willfully overweighting sectors is a form of speculation."