As usual, I will report the performance of both portfolios for the calendar year in January. However, although we are yet to see December out, 2013 is shaping up to be another good year in comparison with both benchmarks and indices. And I remain positive about the outlook for equity markets as regular readers are aware. But an important if understated discipline of investment management is to regularly rebalance portfolios.
The case for rebalancing
My instinct is that 2014 will be a good year for equity markets. Partly because sentiment is unduly pessimistic about both China and the consequences of QE ending, I believe equity investors will be well rewarded by staying invested. However, regardless of how positive one is about the markets or how well a portfolio is performing, history suggests investors should regularly rebalance their portfolios - an understated yet important principle of investing.
The concept is simple. As highlighted in my recent book, if a 40:60 bond-equity weighting is adopted and equities then have a good run relative to bonds, the portfolio could end the period with a 30:70 split. The evidence suggests that it pays to rebalance – back to the original weightings. This is of course provided the factors influencing the decision to adopt the original split - such as one's risk profile and investment objectives - remain unchanged.
Recent history suggests the discipline of rebalancing has worked well. During the period 2007-09, a portfolio starting with a 40:60 split would have lost 37 per cent if unbalanced, compared with a loss of 30 per cent if balanced annually. Longer time frames emphasise the point. Forbes has shown that $10,000 invested 40 per cent in bonds and 60 per cent in equities in the US in 1985, and rebalanced annually, would have been worth $97,000 by 2010. In contrast, the figure would have fallen to $89,000 for an unbalanced portfolio.
The evidence also suggests that a regularly rebalanced portfolio does particularly well when markets fall significantly – which is understandable. Equities have performed better than bonds. Therefore, rebalancing will typically involve reducing the former and increasing the latter. When markets fall, equities usually suffer most as good-quality bonds are seen as a safe haven in troubled times. Rebalancing therefore reduces the impact of market shakeouts.
We should not forget that, over time, an unbalanced portfolio can assume far greater risk than is desired or realised by the unguarded investor - who often only realise their error too late when markets have fallen. Do not be caught out.
One should not rebalance too often. Dealing costs eat into performance. Such costs tend to be far lower for City fund managers than private individuals, and so they can afford to rebalance more regularly. An annual rebalance is about right for most investors, depending on how well markets and portfolios have performed. Such an exercise also provides an excellent opportunity to revisit strategy and holdings.
Portfolio changes
With this in mind, a number of changes were made to both portfolios in November - the objective being to reduce equities and buy bonds, if not bolster cash, while revisiting the merits of existing holdings.
In the Growth portfolio, I have sold Temple Bar Trust (TMPL) and JPMorgan Emerging Markets Income Trust (JEMI). Both have performed well against their peer group and respective benchmarks - each manager being well respected. But both trusts continue to stand at a premium to net asset value (NAV) in areas where suitable alternatives with good track records offer better long-term value.
With some of the proceeds, I have added to the iShares Corporate Bond Fund ex-Financials (£) ETF (ISXF), which yields 4.2 per cent. This brings the bond exposure back up to 10 per cent. For reasons given in my column 'Chicken and egg bond markets' (5 July 2013), the bull run in US Treasuries and UK gilts is essentially over - even though their sustained bear runs may not yet have started. However, decent yielding corporate bonds should continue to do relatively well, at least in the early stages of an economic recovery as insolvency concerns recede. I have added to the ex-financials ETF because I remain wary of bank balance sheets, while accepting they are slowly being repaired.
I have also again added to Utilico Emerging Markets Trust (UEM). This is because of the opportunities presented by the need for infrastructure investment in developing countries - as much to help nurture and sustain economic growth going forward as it is to cater for their growing and increasingly expectant middle classes. UEM stood on a 5 per cent discount when bought and yields 3.3 per cent.
Believing that the UK economy will pick up moderate speed over the next few years, and will be the better performing in Europe, I have continued to increase exposure to UK mid- and small-cap companies. The FTSE 100 companies have less exposure to the domestic economy because of the extent of their overseas earnings. I have added to both JPMorgan Mid Cap Trust (JMF) and JPMorgan Smaller Companies Trust (JMI). JMF stood at an 11 per cent discount when bought and yields 2.5 per cent, while JMI stood at a 14 per cent discount - both discounts are attractive given recent performance and prospects.
Within the Income portfolio, I have made similar changes - reducing equity exposure by focusing on those holdings looking expensive relative to suitable alternatives, and adding to existing bond holdings.
I have sold Murray International Trust (MYI) and the iShares DJ Emerging Markets Dividend ETF (SEDY). MYI was standing at a near 10 per cent premium to NAV and yielding less than 4 per cent. Again, MYI has a very good long-term track record but looked expensive, while SEDY had performed well relative to generalist emerging market trusts because of its income bias.
With some of the proceeds, I have added to existing holdings of ISXF and New City High Yield Trust (NCYF) - the latter yielding 6.5 per cent. This brings the Income portfolio's bond exposure back up to over 35 per cent.
With the remaining proceeds, I have introduced Henderson Far East Income Trust (HFEL) which, while standing at close to NAV, yields 5.5 per cent. HFEL has a good progressive dividend track record and has broadly matched its local benchmark, the MSCI Asia Pacific ex Japan index. Regular readers will know of my preference for the Far East, which both MYI and SEDY captured within their broad remits but to less of an extent than a direct holding allows.
Finally, I have also added to existing holdings of M&G High Income (Income shares) Trust (MGHI) and Standard Life Property Income Trust (SLI). Despite their strong runs, they yield 10 per cent and 6.5 per cent, respectively, and continue to look attractive relative to their specific backdrops.
Otherwise, may I wish readers a Merry Xmas and a prosperous New Year.
View John Baron's updated Investment Trust Portfolio.
