As 2020 draws to a close, it is time for savers and investors to take a long look at their mutual fund portfolios with one question in mind: Should I Juggle my Investments? Let the experts tell you how!
As 2020 draws to a close, investors will be looking to vaccine- and Biden- hopes for some market recovery that will last into 2021. The former because the prospect of bringing covid under control will be a powerful rallying force for global markets. The latter because of the stark dominance of Big Tech and how signally it sustained the S&P500 at ridiculous levels, even during the darkest days of the pandemic in early 2020, prompting market jitters over the prospect of Joe Biden tightening the regulatory framework on tech giants in a values-based approach to financial regulation (more on this in our blog here).
Readers of this blog will remember our 2021 outlook for equities, gilts and bonds (here) in which we discussed some of the economic dynamics that drive the outlook for these instruments in the US, UK and Eurozone. That blog generated so many questions about juggling that we thought we should dedicate a piece to that subject. So here it is.
What is portfolio juggling, and how do I do it?
Juggling your investment portfolio (also know as "rebalancing") is the process of realigning the weightings of a portfolio of assets. Juggling involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk. For example, say an original target asset allocation that conformed to the classic 60/40 split of 60% shares and 40% bonds.
We all know that mutual funds that invest in shares do better over time than funds that invest in bonds. And so, over time, the value of a hypothetical 60/40 investment portfolio that is represented by investments in shares will increase, in proportion to the performance over time of the underlying stocks.
We also know that shares are more risky investments than bonds. And so, just as the portfolio's exposure to shares increases, so does its risk of loss. Hence the need for rebalancing, which is achieved by buying or selling assets in order to bring the portfolio's overall allocation split and risk profile back to what it started out as being (60/40 equities versus bonds, in our example), principally by selling some of what has risen in value the most, and buying more of what has not done as well.
Guarding against this stealth increase in risk profile will obviously be important for older investors, who will prefer to invest more conservatively as they approach retirement age. And, in this sense, the ultimate objective of rebalancing will be to ensure that the portfolio is at its most conservative at the time the investor prepares to draw out the funds to supply retirement income.
How often should I juggle my assets?
Leaving aside the innuendo (!), there are three possible approaches that you could take:
1. Rebalancing at fixed times throughout the year. This could be monthly, quarterly, or once or twice a year.
2. Rebalancing when certain divergence thresholds are reached: This approach clearly entails more vigilance and work for the investor, but has the benefit of limiting the portfolio's tendency to move out of kilter, like many (most?) did in the pandemic market volatility of Q2.
3. This option is a mix of the first two: reviewing at set times in the year, but only making changes if the allocations have reached a certain threshold, like 5% away from where they should be.
We prefer monthly and quarterly assessments, because weekly rebalancing would be overly burdensome, whilst a yearly approach would allow for too much intra-year portfolio drift. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for the retail investor since it involves fewer trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly, like it did in 2020. But then, more dealing incurs more transactional costs, and the average retail investor will have a limited appetite for the kind of time and financial investment that proactive rebalancing entails.
For the majority of retail investors with a basic stocks and bonds portfolio, reviewing just once or twice a year, and rebalancing at 5% thresholds, should be sufficient to guard against material portfolio allocation and risk drift.
Juggling your Portfolio for Asset and Risk Diversification
Market fluctuations over time will inevitably shape your portfolio's exposure to certain sectors and asset classes, resulting in imbalances. For example, should the value of stock X increase by 25% while stock Y only gained 5%, a larger proportion of the portfolio's overall value will be represented by the corporate issuer of stock X. Should the fortunes of that corporate entity take a sudden downturn, your portfolio will suffer proportionately higher overall losses.
Rebalancing is an opportunity for you to take some of the gains achieved by stock X and invest them in other stocks. By having funds spread out across multiple stocks, a downturn in one issuer or sector will be partially offset by the stability or upturns of the others, which can provide a reasonable level of portfolio stability.
So what should I do?
For the majority of retail investors with a basic stocks and bonds portfolio, reviewing just once or twice a year, and rebalancing at 5% thresholds, should be sufficient to guard against portfolio allocation and risk drift. The market turmoil of 2020 has been a lesson in rebalancing for many of us!
What does 2021 hold in store for my Investments?
Recovery hopes were buoyed in Q4 with the UK being the first to approve and roll out a covid vaccine, prompting investors to pile into pharma and healthcare stocks, as well as real bargain propositions like airlines. There were plenty of investors questioning their exposure to US large-cap stocks following Biden's election victory in November. And earlier in the year, as the pandemic unfolded, lots of portfolios were turned over in order to shift them away from income-yielding stocks (with dividends on the floor) to other sectors that were trading at discounts or were positioned as being more covid-proof (like pharma, logistics and home entertainment).
US equities
The Republicans have retained control of the Senate, which allayed the market's fears over Biden's desire to regulate Big Tech and adopt a values-based approach to financial regulation. Capitalism is a coward, and many market commentators welcome political and legislative inhibitors on Biden's ability to make changes to certain industry sectors and financial systems.
Our view is the Biden presidency most likely signifies a continuation of the status quo for Big Tech, oil an gas. Clear winners under Biden will be pharma and healthcare as he seeks to get control of the coronavirus and reinstate Obamacare.
The position in the Senate also suggests that the Fed's support of UK markets, that provided a huge psychological boost for US stocks in Q2, will continue.
You can read more about the impact of Biden on your investments in our blog here.
Our 2021 outlook on US equities is Positive.
UK equities
UK indices, which have been significantly trailing the S&P500 this year, can be expected to rally on news that the UK has been the first country to approve a covid vaccine.
Many large-cap UK companies are still trading at significant discounts to their value, with covid resurgence and Brexit worries priced in. Retail investors withdrew £2.7bn from investment funds invested in UK stocks in Q3, with asset allocators placing a sizeable discount on London listed companies. This has left UK investments looking decidedly cheap. With the Brexit process due to be completed by 31 December, thereby restoring some certainty to the UK stock market, many FTSE100 stocks will not be cheaply priced for much longer. For more information on UK buying opportunities, see our blog here.
Our 2021 outlook on UK equities is Neutral-to-Positive.
European equities
The European Central Bank (ECB) provided welcome support for the Eurozone economy, together with a recovery fund to channel resources to the hardest-hit parts of the European economy.
In addition, European stock markets, unlike those in the US, do not suffer from a glut of large- and mid- cap technology companies that look somewhat overvalued and combine to maintain the index at what many on Wall Street consider to be a precariously and unsustainably high level.
That said, the resurgence of covid across Europe and uncertainties about the degree to which fiscal stimulus will be provided by the European Central Bank, combined with the UK's departure from the bloc and the current absence of a centrally-approved vaccine in the EU, have caused European indices to lag behind the S&P500. Recent news on the efficacy of vaccines being developed in Europe are cause for confidence, however.
You can read more of our views on European equities in our blog here.
Our 2021 outlook on European equities is Neutral-to-Positive.
Government Bonds
The pandemic has dealt a major blow to yields on government bonds and gilts, with yields so low as to be negligible in many cases.
Q3 saw a low volatility environment compared to previous years, as sentiment around the macro backdrop and the covid recovery improved. Ongoing growth in central bank balance sheets proved a boon for risky assets. There is a view that developed government bond markets are on a path to “Japanification”, with economic data having little impact on prices and a larger share of the market owned by domestic commercial banks, a trend that is becoming particularly evident in the US. We think that yields are therefore likely to stay within the tight ranges that were in play over Q1 and Q2, with any yield increases likely to be short-lived.
Current government spending is unlikely to be enough to carry economies till the “end” of covid, and this is particularly the case in Europe, where the room and willingness to manoeuvre appears less than in the US or the UK.
US government bonds
US government bonds are beginning to look interesting again, with the recent rise in yields offering some protection if US economic growth disappoints over 2021. Yields on U.S. government bonds had stalled near all-time lows. The yield on the benchmark 10-year Treasury note ended Q3 at 0.69 % from 1.88% at the beginning of the year. The 2-year note yield tumbled to around 0.13% at quarter-end. We have a fairly favorable outlook for investment-grade corporate bonds, and we are also finding opportunities in high-quality securitized assets, including AAA-rated asset-backed securities.
Our 2021 outlook on US Treasuries is Neutral.
UK government bonds
The return on UK gilts is on the floor. Comparative to US Treasuries and EU government bonds, there is disappointingly little value in UK government debt given their poor relative returns compared to other developed markets.
Unemployment is expected to rise in the UK in 2021 as the fiscal packages to support workers are curtailed, which in turn will place downward pressure on wage inflation. Whether that is enough to reduce CPI levels or at least not allow them to increase too much more is yet to be seen.
Our 2021 outlook on UK government bonds is Negative.
European government bonds
Eurozone government bond yields hover near record lows thanks to the ECB fiscal stimulus, and investors have to look elsewhere for income.
Aside from the G8 European issuers, peripheral euro zone sovereign debt yields nudged higher over November as new lockdown measures in Europe increased the demand for safer assets. Yields had dipped previously when the European Central Bank gave a clear signal that it will provide more quantitative easing in the eurozone in December.
Most of the Eurozone represents an expensive market, and the strong Euro makes EU government and ECB debt expensive.
We think that European rates will remain pinned down by both central bank intervention, and by flight to quality flow, with 10-year Bund yields heading lower to -0.70%.
Current government spending is unlikely to be enough to carry economies till the “end” of covid, and this is particularly the case in Europe, where the room and willingness to manoeuvre appears less than in the US or the UK.
Our 2021 outlook for Eurozone government bonds is Negative.
Corporate Bonds
Whilst the coronavirus dealt a major blow to yields on government bonds and gilts, it is a different story for corporate bonds, however, with the spread (ie., the difference between corporate bond yields and those of government bonds) falling back to pre- COVID levels.
Many investors and fund managers are of the view that credit is the place to be, with attractive coupons (ie., the interest rate paid on the bond's face value by its issuer) being offered by companies desperate to shore up their balance sheets in preparedness for the covid uncertainties of 2021.
Bonds issued by companies with healthy balance sheets and cash reserves have provided investors with a good hedge against a Second Wave. And corporate bonds are particularly attractive in low- interest rate environments, in which the incidence of issuer default is typically low.
The extraordinarily low yield environment encouraged corporations to issue new bonds, retiring debt with higher interest rates.
We think that the boost to economic growth from fiscal and monetary stimulus earlier in 2020 is likely to sustain the market’s recovery into Q4. A delay in additional stimulus, high unemployment and the continued economic impact of the virus will potentially weigh on economic growth in 2021.
The market for US investment grade bonds and junk (high-yield) bonds continued to recover as spreads, or the risk premiums over Treasuries, narrowed during Q3.
US investment grade
US economic fundamentals are weak, but the Federal Reserve (Fed) is expected to remain supportive by extending its purchasing scheme and signalling a shift for setting its monetary policy, allowing for a rate environment that will likely be "lower for longer".
Democrats and Republicans have been at an impasse over the next virus relief bill. Our view is the economy and risky assets would struggle in the absence of a new round of stimulus. Against this backdrop, the Fed expects the economy to contract by 3.7% this year, before bouncing by 4% in 2021.
We have a fairly favourable outlook for US investment-grade corporate bonds, and there may also be some opportunities in high-quality securitized assets, including AAA-rated asset-backed securities.
Our 2021 outlook for US investment grade bonds is Neutral-to-Positive.
US junk
We think that US high yield bonds are less attractive than their European counterparts. In mid-October investors flocked to US junk bonds on vaccine hopes bolstering riskier corporate borrowers, but borrower defaults over Q2 and Q3 are worrying.
The 2021 outlook for the US junk bond market depends on the extent of dividend recovery. The future for dividend payments based on historical data does not look bright, with the bear market of dividends lasting much longer than their total return (growth and income) counterparts, on average lasting 4.8 years compared to 1.5 years.
A relaxation of lockdown rules in the US 2021 would lead to substantial recovery of the economy and result in dividends returning, but we think that the US economy is unlikely to return to anything like ‘business as usual’ for some time, particularly if covid does not dampen down, and Biden gets tough both with the virus and with those States that were resistant to imposing lockdowns in 2020.
Our 2021 outlook for US high yield bonds is Neutral.
European investment grade
Economic fundamentals in Europe (including the UK) are weak, but demand for investment grade corporate bond issues by European issuers is robust due to the ECB increasing its purchases back to levels seen in March and June this year. And with many large European companies having built up war chests over 2020, we may expect them to remain fairly safe issuers in 2021.
Our 2021 outlook for European investment grade bonds is Neutral to Positive.
European junk
Investors piled into bonds issued by some European companies vulnerable to the pandemic last week, even as a Second Wave of covid was threatening to bring the summer economic rebound grinding to a halt, largely because corporate default rates in Europe and the UK are projected to be lower than thought at the start of the pandemic.
We prefer European high yield bonds to US high yield bonds because of the ongoing fiscal support that the ECB has indicated will continue to be made available in 2021 in the form of the pandemic emergency purchase programme (PEPP).
There are, however, covid inhibitors on optimise for European and UK high-yield debt. If the consensus assumption, that a second hard lockdown of the economy can be avoided, proves wrong, this would clearly introduce some substantial setback potential for risker corporate debt issuers.
Our 2021 outlook for European high yield bonds is Neutral to Positive.
You can read more of our views on European corporate bonds in our blog here and our Q3 UK and US investment outlook here.
MATTHEW FEARGRIEVE is an investment management consultant. You can read more of his blogs here and see his Twitter feed here.
Comments