What Risk-based Rebalancing Brings To The Table

Our Head of Portfolio Construction, Richard Yeh, recently shared with The Business Times how Syfe’s risk-based rebalancing strategy keeps our clients’ portfolio allocation at its most optimal, no matter which way the market swings.

Richard’s byline piece, titled “The value of risk-based rebalancing”, examines how risk-based rebalancing changes portfolio allocations in response to a sustained increase in market risk to mitigate losses and help investors stay invested for the long haul. When investors are assured that their portfolio risk is always in sync with their risk tolerance, they are less likely to panic sell their investments in a downturn, thus paving the way for long-term investment success. 

The following is a brief summary of the article. 

In risk-based rebalancing, a rebalancing is triggered when the risk within a portfolio either exceeds or falls below an investor’s desired risk level. If portfolio risk increases beyond an investor’s risk threshold – and the portfolio is not rebalanced back to its intended risk level – the investor is taking on more risk than what they are comfortable with.

To better understand the benefits of risk-based rebalancing, let’s look at how a hypothetical investor with a 15% Downside Risk portfolio would have fared during the 2008 global financial crisis. (This 15% Downside Risk represents the investor’s risk threshold. In other words, it means that they are comfortable with a 97.5% chance that their portfolio will not lose more than 15% in a given year.)

Weeks before the economic crisis began in earnest, the portfolio had an asset allocation of 39% equities, 50% bonds and 11% commodities. But by late September 2008, Syfe’s Automated Risk Managed Investing (ARI) algorithm had detected increased tremors of market volatility and forecasted even higher volatility ahead. 

Before the portfolio was rebalanced, the chart on the left is how the risk projection of the 15% Downside Risk portfolio would have looked based on its original asset allocation. 

Syfe conducts such risk projections daily using Monte Carlo simulations to predict thousands of possible future market scenarios and calculate the probability of each one happening. The upper bound of the curve (in blue) corresponds to the best-case scenario generated while the lower bound of the curve (in red) corresponds to the worst-case scenario generated.

The chart on the left shows how the projected loss potential had exceeded the portfolio’s Downside Risk Target (indicated by the green zone). This projection meant that in more than 2.5% of all forecasted scenarios, the portfolio could lose more than 15% of its value that year. This potential loss would have been far greater than what the investor would have been prepared to lose, given his particular risk profile. 

To return the projected loss potential to within the portfolio’s Downside Risk allowance, ARI adjusted the portfolio weights to a less risky allocation by reducing the percentage of equities and increasing the percentage of bonds. The chart on the right shows the new risk projection after rebalancing. There is a more narrow U-shaped curve, reflecting how risk-based rebalancing has reduced the likelihood of the portfolio losing more than its downside risk target to the very minimum.

Switching into lower-risk assets better protected the portfolio and allowed the investor to dodge a large part of the worsening downturn. Comparing the Syfe portfolio with a benchmark Morningstar Moderate Index (which corresponds to a 60% equities and 40% fixed income medium risk portfolio), we see how risk-based rebalancing partially insulated the portfolio from the market crash. The benchmark portfolio, which followed a calendar rebalancing, was however exposed to the full brunt of the financial meltdown. 

Ultimately, Syfe’s risk-based rebalancing strategy delivers better risk-adjusted returns over the long term because portfolio risk is continuously monitored and kept from deviating away from its target level. 

For more insights on the value risk-based rebalancing can bring to your portfolio, read Richard’s complete byline here.  If you think risk-based rebalancing is the right strategy for you, start by finding out the ideal asset allocation for your portfolio.