Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Today, we're going to be talking about rebalancing, and that's the idea of de-risking your portfolio or moving your portfolio back in line with the asset allocation targets that you had made if your assets have really come very far from those allocations. Today, joining me is Tim Murphy. He's a Director in our Manager Research team and he also overseas Morningstar's model ETF portfolios.

Tim, thanks very much for joining us.

Tim Murphy: Hi, Emma. Glad to be here.

Rapaport: Tim, before we start talking about how investors might start thinking about rebalancing before the end of the year, why do investors rebalance? What's the payoff for investors for doing this?

Murphy: Yeah. Well, if you think about when you first set up a portfolio, ideally, you have some sort of strategy around that and then you allocate assets accordingly. And so, you make X percent allocation to, whether it's domestic equities split amongst either shares or ETFs or managed funds even, and you might do the same globally. But then, over time, obviously, those assets perform differently. And so, the weights and exposures you started out with can look very different depending on what market returns have looked like. And in the last year, we've seen some very big dispersion in market returns, particularly between equity markets and bond markets if you've got more of a conservative portfolio and have some bonds and fixed income in there.

But to put some numbers on that, like in the 12 months through the end of October, Aussie equity market is up circa 28% depending on which index you use; global equity markets are up 30% plus, again, depending on the market you've been exposed to; and obviously, there's been individual pockets and stocks within that that have done much, much better than that. On the flipside of that, if you've been in cash or fixed income, we all obviously know cash rates have been quite low and close enough to 0. So, you haven't earned much return there. And then, within the bond market, as we've seen, interest rate rises in the bond market this year has actually led to slightly negative returns in bonds. And so, if you started out from just a year ago, with something of a balanced portfolio, your equity weightings are going to be far, far higher than what they were a year ago relative to the conservative part of your portfolio. And so, therefore, your strategy today is actually taking a lot more risk than what it was a year ago, which might be counterintuitive given the run-up in markets we've seen.

Rapaport: Is there a particular number or a particular amount that you would suggest investors start thinking about rebalancing when they get far from their target asset allocation?

Murphy: Yeah. Certainly, it's a topic that's been the subject of much academic debates and discussion and research and whatnot, and there's no silver bullet to it. So, I think, there's some rules of thumb that we commonly see applied, and so then we apply it to some of the portfolios that we run and how we think about it. Certainly, if you think about tolerance bands around your strategic weights to certain assets, that might be plus or minus 5%, plus or minus 10% if you've got more tolerance to let those things run. From a timing perspective, others like to do it so that they are dollar cost averaging over time, particularly if they're putting money in, or if you're in drawdowns, the same kind of effect on the other side. So, thinking about rebalancing, whether it's every quarter, every six months, or possibly every year, there's no right answer to that. But having some sort of disciplined process around that upfront so that you do not make it up on the go, actually, is likely to lead to better return and outcomes over time and not taking undue risk that might creep into your portfolio without realizing.

Rapaport: Yeah, I'm really curious about these sort of calendar dates that we put around rebalancing – quarterly, half yearly, annually. Is there a time where – I do think it's good that we say, at the end of the year, we'll review our portfolio and rebalance. But if your portfolio hasn't moved that much, is it actually worth doing it at the end of the year, or are there other times you should look for doing it?

Murphy: Well, if over the course of a year, it hasn't moved, I think there's a good discipline in actually going through the process, but then not actually doing anything. And so, I'd describe that as actively doing nothing. But that's still an active decision, right, that you're still – it's a commonsense check. Your strategy is still in place, it's in line with what you set out to do, it's taking on the level of risk that you aim to do. And so, the fact that assets may not have moved materially still doesn't negate the need to go through that process, I think. Inevitably over time though, particularly where you've got equity market exposure, equity markets tend to move up and down in often rapid amounts, and obviously, in the last 18 to 24 months, we've seen some fairly rapid movements, down to begin with at the start of the pandemic, and obviously, fairly strong up movements in the last 18 months since then. And so, if you had set a portfolio in place 18 months, 12 months ago and done nothing since then, then your strategy looks quite different today than what it does then, and you've got more risk in your portfolio just from a pure equity exposure perspective given the market movement than you might have intended to have. And so, I just think having that discipline really, I think, leads to better outcomes over time.

Rapaport: Yeah. Like on the flipside, is there a bad time to rebalance? Is there a time where it wouldn't be good for somebody to do it?

Murphy: There isn't necessarily a bad time. I mean it can – there are times that it can obviously work out bad. So, if you – let's say, you took money off the table today because equity markets have run up and you rebalance and put more of that back into bonds. And then, in the next 12 months, we have a repeat of the last 12 months and equity market were up 30%, then you could sit here in 12 months' time and say that was bad, or that led to a lower amount in my portfolio. But at the same time, given where we're looking at valuations now, we think it's probably prudent to be at least rebalancing and take a little bit of the money off the table, and you're making sure that you've got more appropriate risk settings in place so that if we had a 20% equity market correction that you're not overly exposed to that which you are or would be today if you have not done anything in terms of rebalancing or (filling) down some of the gains that you've made in the last 12 months.

Rapaport: Yeah. So, you spoke about the run-up in the equity markets, you spoke a little bit about bonds. But what about on a more granular level? Do you consider rebalancing to also be in questions like what sector am I exposed to, what geography am I exposed to, am I maybe overexposed to a factor like growth or value?

Murphy: Yeah, absolutely, and that's certainly been a big theme in equity markets for the last decade, with growth significantly outperforming value over that time period, at least in the last 12 months where it has been a little more even between value and growth during the time period. But certainly, at a sector level and at a regional level, only the U.S. has consistently outperformed most other regions around the world for the last few years. The technology sector has certainly been home, particularly the mega cap end, to some of the best performers in the market. And so, certainly, if you've got exposure to any of those, whether it's direct stocks, whether it's ETFs that are heavily exposed in that area, then absolutely it makes sense to, sort of, reevaluate the level of risk that you're incurring and taking and making sure that you're comfortable with that. And if you're not, and yet that is out of line with the strategy that you put in place to begin with, then thinking about rebalancing and taking some money off the table there accordingly.

Rapaport: You spend a lot of time surveying the Australian funds market and having a look inside portfolios of various equities managers. Are there any specific types of portfolios or types of fund managers that you feel have gone way up on the risk spectrum that investors should be a little bit wary of and maybe thinking of taking some money off the table?

Murphy: Yeah. So, certainly, we've seen wide dispersion in the performance of managers. Generally speaking, over the last five years, as I touched on, growth managers have significantly outperformed value managers. That's a general theme. So, certainly, we look at the returns that have been achieved there, if you've been exposed to some of those very high growth – if you've been exposed to many of those high growth managers, or ETFs with that exposure within them, then we think it is prudent to reconsider the weighting in those, because we would say those types of investment strategies are more exposed to a pickup in interest rates and inflation, which is certainly topical at the moment. When you think about the discount rate that's been only applied to future earnings of stocks, those discount rates have been pretty low and have been shrinking in recent years, which has helped propel many of these high-growth stocks particularly in sectors like technology, as I mentioned, to far exceeding market returns. Now, the flipside of that can obviously happen. We do see a continued rise in inflation and interest rates and therefore, implied discount rates. That's likely to hurt some of the more growth-oriented sectors than not.

Rapaport: Yeah. And just finally, I know that you're not a tax expert, but obviously tax is one of those things that investors consider when they're rebalancing. Are there particular types of strategies that investors can employ that are the most tax-efficient? Should they be considering things like when they first purchased those assets and whether or not they're still within a sort of one-year capital gains period?

Murphy: Absolutely, 100%. So, being very conscious of your holding period and if you're at or around that 12-month period as you touched on, if you're sitting on gains, it clearly makes sense to consider or make sure that if you're close to that 12-month period, you hang on for that so that you are eligible for the capital gains tax discount. That goes without saying. I think moving beyond that, and generally, more of the discussion around towards end of tax year around things like tax loss harvesting. So, if you are having some stocks that have fallen in value over your holding period and you've got others in your portfolio that have gained and you're looking to sell down, then tax loss harvesting to offset some of those is a legitimate strategy that certainly we see making a lot of sense in terms of managing a portfolio from an optimal tax perspective.

Rapaport: Great. Okay. So, the message for investors is go back to the investment policy statement, go back to your asset allocation, what your target was at the end of the year, think about it, see how far you've moved and consider rebalancing.

Murphy: Absolutely. It's always prudent to have some sort of structure and regularity around how you think about your portfolio strategy. And if you've moved away from that, really think about getting back to that whether it's through rebalancing or buying and selling other assets.

Rapaport: Great. Tim, thank you very much for joining us.

Murphy: Thanks, Emma.