- Set limits for portfolio weights to drift from a strategic asset allocation.
- The goal is to provide flexibility to minimise dealing costs, run winners and control risk.
- Stage five of our Twelve Steps of Portfolio Management
With a benchmark strategic asset allocation (SAA) framework decided, the next step for investors is to create a set of rules for rebalancing asset weightings and staying within the portfolio risk budget.
We aim to keep downside risk to a level where we can be 99 per cent confident daily losses won’t exceed -3.11 per cent and maximise the Sharpe Ratio (rate of return above the risk-free rate per unit of volatility) of our portfolio. This is while minimising the amount of times we must rebalance to save on costs.
The framework we continue to examine is based on the maximum utility a UK investor (so returns in pounds) with Moderate Risk tolerance would gain from a multi-asset portfolio strategy. Using data going back to 1978 to take in a variety of conditions, the initial modelling suggested an a blend of four core assets - UK shares (mixed market caps), Global shares (hedged to GBP), UK Government bonds (gilts) and US Treasury bonds (unhedged to give US dollar haven exposure).
ETFs available to replicate this system have only fully been available since 2019 - we follow our strategic asset allocation weightings and also play around with the notion of our 'risk budget' from this mix of investments to also suggest an alternative strategy. In Step 4 we set a limit, consistent with our long-run allocation back to 1978, that we wanted to be 99 per cent confident the maximum daily peak-to-trough drawdown from any mix of assets we owned was -3.11 per cent. We also only allowed movement in the international allocations within asset classes - we didn't allow changes in the shares to bonds asset mix. With these parameters in place the best risk-return trade-off available from our core strategic assets had much more of a bias to global, as opposed to UK, shares.
Arguably, the UK-centric approach is representative of the opportunity set sterling investors could have accessed over the whole 45-year period, but going forward most are likely to think globally. Maintaining a risk-budgeting link between the historical model and the optimised mix of an investable universe over four years seems a good compromise. In any case, we will build portfolios with reference to both strategic models.
Tolerance bands for rebalancing investment portfolios
On another practical level, although models are constructed on the assumption of constant weightings, because assets perform differently there is inevitably drift. Rebalancing at the end of every trading day is costly and impractical but what is the optimal way to keep to a strategy, manage risk and minimise expense?
The tolerance band approach is one answer. This works using the equation of absolute value of existing portfolio weights divided by the portfolio value minus the sum of strategic weights. In this equation, the sum of existing portfolio weights is the numerator. Portfolio value minus the strategic weights is the denominator.
Using a solver function, in a process explained in this video by NEDL, it is possible to optimise the percentage we allow the portfolio weights to deviate before triggering a rebalance. This works out that a tolerance band of 8 per cent drift is optimal for both our SAA models: it achieves the best Sharpe Ratios and most importantly keeps the strategies comfortably within our risk budget at the 99 per cent confidence level.
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