Long-term investing: A balancing act

To stay true to your risk profile and investment goals, your unit trust portfolio should be reviewed and rebalanced (or ‘switched’) annually,  to keep up to date with changing market values.  Think of it as a yearly milestone, like celebrating your birthday. 

In the beginning

When you first sit down with your financial adviser to plan for your future, things should be fairly cut-and-dried. Once your risk profile and investment objectives have been determined, your adviser will allocate your investments across unit trusts with appropriate asset classes. These could range from high-equity offshore unit trusts (which carry a relatively high level of risk) to money market unit trusts, which are more stable and provide consistent interest income.

But over time, the returns of the various unit trusts will differ, and the overall asset allocation may no longer be aligned with your initial investment objectives. Professionals refer to this as ‘portfolio drift’.

What is rebalancing?

Rebalancing, which is also often referred to as switching, is the process of readjusting the overall asset allocation in your portfolio to maintain your original longer-term objectives. This entails buying and selling unit trusts to reweight asset allocation to align with your risk profile.   

You can also think of it as selling high and buying low – a universally adopted investment strategy. In other words, you’re using profits from your better-performing unit trusts to buy more of the weaker-performing assets. This may seem counterintuitive, but it works.

The arguments against rebalancing

As rebalancing involves selling the best-performing unit trusts within your portfolio, you may incur capital gains tax: 40% of the capital gain is added to your income and then taxed at your marginal tax rate. There is, however, an annual exemption on the first R40 000 of gains across your investment portfolio. And another notable exemption is if you switch funds within a retirement fund or living annuity, as capital gains tax does not apply to such investments.

There may also be transactional costs if your adviser charges an upfront fee when you purchase unit trusts. This shouldn’t be the case for much longer, as there’s a trend towards no upfront fees which is in line with new legislation regarding “Retail Distribution Review (RDR)”. After all, you shouldn’t be penalised for adhering to a sound investment philosophy.

And of course, there is the hassle factor. Can you justify making minor adjustments when your time is so precious? The answer to this question is a resounding “yes”! 

The (resounding) case for rebalancing

The advantages of a sound investment philosophy always outweigh the disadvantages. 

A significant pro of ongoing rebalancing is that you can benefit from the R40 000 capital gains tax exclusion every single year. This means that your base cost is repeatedly reset at a higher level, which assists in reducing your gain on future unit trust sales. It could also come in handy in minimising estate duty on your passing, as this too may be subject to capital gains tax. 

But far and away the most significant benefit of rebalancing your portfolio is that it keeps your risk in line with your investment objectives and risk profile. Without rebalancing, you may expose yourself to too much risk, which is tempting when times are good, but could result in heavy losses if you panic and sell at the bottom of an investment cycle. Conversely, if your portfolio becomes too conservative, you will probably not achieve your long-term objectives.

How often should it be done?

Many professionals recommend rebalancing annually.  This is aligned with the legal requirement for advisers to review their clients’ portfolios at least once a year. Other experts say you should rebalance your allocations when you’re 5% off target.  This involves constant monitoring and could include an attempt to time the market – something no one can get right every time. 

The nitty gritty

If your adviser has created a unit trust investment account on a linked investment platform (LISP) which includes different unit trusts, you will typically be asked to sign a switch form, which changes the percentage allocation of each unit trust relative to the whole fund.

Another opportunity to rebalance is when making additional contributions or withdrawals from your investments. If you have additional funds to invest, you could buy more of the unit trusts that have underperformed the most and thereby caused the deviation from your original allocation.  If you need to withdraw funds, you can sell some of the unit trusts that have deviated positively from the ideal allocation. 

The final word

No matter how unnatural rebalancing seems, it is a vital part of managing your unit trust portfolio.  No one knows what asset class or investment strategy is going to be the “winner” each year, and trimming back on the strongest performers allows you to buy less risky funds.  This protects your gains and enables you to reap the full rewards of diversification. 

Contact your financial adviser if you’d like to discuss rebalancing your unit trust portfolio. To find out more about Prudential funds, contact our Client Services Team on 0860 105 775 or at query@prudential.co.za