Morningstar's Christine Benz and other financial experts weigh in on what to do when a sound portfolio practice collides with an unattractive asset class.
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By Christine Benz | 04-19-13 | 06:00 AM | Email Article

You've entered your holdings, reviewed your portfolio's X-Ray, and compared your asset-allocation weightings with your target allocations. As you conducted your checkup, one fact may have become painfully obvious: It's time to rebalance back into bonds.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

After all, the broad U.S. stock market has risen 11% on an annualized basis during the past three years, whereas the Barclays Aggregate Bond Index has gained just a bit more than 5%. That market action means that a portfolio that was balanced 50/50 between stocks and bonds three years ago would now be 53% equity/47% bonds. For those who aim to gradually take risk off the table in anticipation of retirement, the recent equity rally may well have taken their portfolios' weightings out of whack with their targets.

Trouble is, bonds aren't especially attractive at this juncture. Even if you don't have a crystal ball handy, it's easy to see that the raw materials for strong returns from the fixed-income asset class aren't especially promising. Current yields have historically been a good predictor of fixed-income returns during the subsequent decade, and the yield on the Barclays Aggregate Bond Index is less than 2% currently. Moreover, with interest rates as low as they are right now, bonds are extremely unlikely to enjoy the same capital appreciation they derived from declining rates during the past few decades. Grantham Mayo Van Otterloo, whose seven-year asset-return forecasts have a strong long-term record, is forecasting negative real returns for most bond types, save for emerging-markets debt.

The Case for Rebalancing
What should you do when a sound portfolio practice--rebalancing--collides with an asset class that appears unattractive? Should you seek out parts of the bond market that could fare better in the years ahead or consider alternative asset classes such as dividend-paying stocks in lieu of buying bonds? Or should you just call the whole thing off?

At first blush, blowing off the rebalancing--at least this time around--might seem like the right course of action. Stocks aren't a screaming buy, according to the average price/fair value ratio for stocks in Morningstar analysts' coverage universe, but nor are they dramatically overvalued. Why sell a not-unreasonably valued asset class in favor of one that could be in a bubble?

It might also be difficult to grasp the long-term case for rebalancing, particularly when you consider that the practice can trigger tax and transaction costs. There's also the fact that stocks generally outperform bonds over long time periods. In a Vanguard study harnessing historical market data from 1926 through 2009, a nonrebalanced 60% equity/40% bond portfolio would have generated a slightly higher annualized return--9.1%--than one that was rebalanced at least some of the time. For rebalanced portfolios, annualized returns during that same time frame ranged from 8.5% for a portfolio that was rebalanced monthly, regardless of changes in asset-class weightings, to an 8.9% annualized gain for a portfolio that was rebalanced on a quarterly basis if its asset-class weightings diverged by 10 percentage points from the 60% equity/40% bond target.

Instead, rebalancing's biggest contribution comes in the realm of risk reduction. The nonrebalanced portfolio in the Vanguard study had a standard deviation of 14.4% from 1926 through 2009, whereas the rebalanced portfolios all had standard deviations of about 12%, regardless of the rebalancing interval. That's a lot of volatility reduction without a substantial drop in long-term return.

'Just Do It'
That said, rebalancing usually makes more sense from an intuitive standpoint than it does today, provided one is comfortable taking a contrarian stance. Rotating into bonds at the peak of the tech market boom or moving into stocks at the market's nadir in late 2008/early 2009? Psychologically difficult, sure, but eminently sensible from a valuation standpoint. By contrast, plugged-in investors might view a shift into bonds at today's depressed yields as a sucker's move.

Nonetheless, several financial planners and experts I have talked to agreed that it's unwise to second-guess rebalancing your allocations when they fall out of line with your carefully considered targets, provided you've decided to use an asset-allocation approach that's strategic rather than tactical. Morningstar head of retirement research, David Blanchett, said, "My overall theme on rebalancing can be summed up by  Nike's slogan 'Just do it.'"

Leisa Brown Aiken, a financial planner at Veo Financial Counsel in Chicago, concurred that it's unwise to get bogged down in the timing question. "We recommend consistent disciplined rebalancing because we can't predict equity market returns, though based on history we expect them to be higher than bond market returns over time."

Despite bonds' lower return potential, the key advantage of rebalancing back into them, Aiken noted, is the risk-reducing and diversifying effect they can have for an equity-heavy portfolio. "Most investors 'need' bonds because the potential downside is less than the downside risks of stocks, and most of the time the returns don't move in lockstep."

Financial planner Roger Wohlner of Asset Strategy Consultants in Arlington Heights, Ill., agreed that bonds risk-reducing effects are more important than their meager return potential. "While I get that bonds are not a real attractive place to be and that stocks appear to be the vehicle of choice," he said, "to me rebalancing is about risk control first."

'I've Been Watching Duration'
Yet even as these financial experts caution against second-guessing rebalancing at this juncture, most said they would recommend some tweaks to the fixed-income holdings to mitigate the risks baked into the asset class.

For Wohlner, limiting the interest-rate sensitivity of the fixed-income holdings is one way to ensure that the fixed-income portfolio remains low-risk. "One thing that I am doing to an extent with clients is shortening up on the duration [a measure of interest-rate sensitivity] of bond funds and exchange-traded funds. The timing of this might be early, but again this is part of risk control."

In addition to emphasizing short durations, Aiken is looking to control fixed-income risk in other ways, too. "My guideline would be to reduce the overall duration to no more than 4-5 years and use a mix of short- and intermediate-term bond funds with high credit quality and low expenses. This limits but does not eliminate the potential downside risk from rising interest rates."

Sue Stevens, CEO and chief investment officer of Stevens Wealth Management in Deerfield, Ill., is positioning client bond portfolios in a similar band. "I've been watching duration across all portfolios. I'm aiming for 5 or less."

Stevens says she has also been adding to active bond portfolio managers with flexibility built into their strategies, noting that many such managers have fairly short durations these days. Among the holdings on her radar are  DoubleLine Total Return Bond ,  PIMCO Unconstrained Bond , PIMCO Unconstrained Tax Managed Bond ,  PIMCO Floating Income , and  PIMCO Income .

As important to Stevens' risk-reduction strategy is what she's been avoiding. "I've been reducing the amount I have in Treasuries and TIPS [Treasury Inflation-Protected Securities]," she said. "There's not much chance of inflation anytime soon, and it's hard to sit in a fund where you know you'll get a negative return. Vanguard has a new short TIPS fund out that makes sense if you really want TIPS exposure. But it's probably going to have a negative return."

'Look Into Other Investments'
Blanchett, though a firm believer in the concept of rebalancing, notes that an investor needn't necessarily move all stock-rebalancing proceeds into bonds. "For some investors it might be worthwhile to look into other investments, which, while not as conservative as bonds, could potentially offer a higher return. For example, high-yield bonds, commodities, real estate, and high-dividend stocks are examples."

To help offset the greater downside potential of adding to these nonbond asset classes, Blanchett offered the following workaround. "One potential option is to cut back on the super-high-risk asset classes, such as emerging markets, if you're going to increase your allocation to other nonbond asset classes."

Stevens, who takes a largely strategic approach to asset allocation and rebalancing but allows for modest tactical tilts, agreed that increasing equity allocations by a small amount may be in order for some portfolios, despite the extended equity rally. That's because some of her clients reduced their equity weightings and plowed money to bonds during the bear market; they haven't brought their portfolios back in line. "Shifting 5%-10% more toward stocks, as we see buying opportunities, will help shift these portfolios back toward a more traditionally weighted portfolio mix."

A version of this article appeared March 4, 2013.

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