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  • Writer's pictureWinfrid Jonathan

Overlooked Benefit of Rebalancing Portfolios – Robo Advise

Updated: Nov 1, 2023


We explore the world of Robo-advisors, their fixed asset allocation strategies, and an often-overlooked benefit of rebalancing

Introduction

In the world of wealth management, Robo-advisors have gained popularity for their efficiency, cost-effectiveness, and accessibility. These automated investment platforms offer investors an easy way to manage their portfolios without the need for a human financial advisor. In this blog, we will explore the world of Robo-advisors, their fixed asset allocation strategies, and an often-overlooked benefit of rebalancing: indirectly selling volatility (which can earn outperformance). By the end of this article, you will have a clearer understanding of the advantage that Robo-advisors may present for your investment needs.

The rise of Robo-advisors

Robo-advisors are digital platforms that utilize algorithms to manage clients' investment portfolios based on their financial goals, risk tolerance, and investment horizon. These platforms have grown in popularity due to their lower fees compared to traditional financial advisors and their ability to provide personalised investment advice to a broader range of investors online.


Fixed asset allocation and rebalancing

One of the critical components of many Robo-advisors' investment strategy is the concept of fixed asset allocation. This approach involves assigning a predetermined percentage of a portfolio to different asset classes, such as stocks, bonds, global equities, and cash. The allocation is designed based on the client's risk tolerance, financial goals, and investment horizon. Robo-advisors typically monitor the performance of each asset class closely and may rebalance the portfolio when certain triggers are met. These triggers could include a specific percentage deviation from the target allocation or a predetermined time interval, such as quarterly. Rebalancing involves selling assets that have outperformed and buying assets that have underperformed, effectively bringing the portfolio back to its original target allocation.


The overlooked benefit: indirectly selling volatility

One often overlooked benefit of rebalancing portfolios is the indirect selling of volatility. This concept can be better understood through the analogy of selling options. When selling a put option for example, the seller indirectly "sells" the underlying asset when the market rallies and keeps the premium received from selling the put option. Conversely, when the market falls, the seller is indirectly buying more of the underlying asset and may have to fulfil the obligation to buy the underlying asset at the strike price – but keeps the option premium received by selling the put. Selling a short dated out of the money option is selling market volatility. Similarly, when rebalancing a portfolio, an investor is effectively selling assets that have outperformed and buying assets that have underperformed - akin to what happens when you sell an option. This process indirectly captures a premium as rebalancing is like selling volatility, as a source of return, potentially leading to outperformance compared to a portfolio that is not regularly rebalanced. Numerous research studies have highlighted the importance of good asset allocation in determining a portfolio's performance. A seminal study by Brinson, Hood, and Beebower (1986) found that asset allocation accounted for over 90% of the variation in a portfolio's returns, emphasizing the significance of a well-structured allocation strategy. Subsequent research has further corroborated this finding, reinforcing the notion that a diversified allocation across various asset classes can help optimize returns while minimizing risks. Part of this is due to the rebalancing process that assists in producing superior returns. It is essential to note that selling options and rebalancing a portfolio are not the same activities, and their risk profiles and objectives can differ significantly. The analogy serves to illustrate the potential benefits of rebalancing which can assist with outperformance with the potential to add an additional source of return.


Benefits of Rebalancing in Robo-Advisors

Incorporating rebalancing into a Robo-advisor's investment strategy offers several benefits, including:

  • Risk Management: Rebalancing helps maintain the desired level of diversification, ensuring that the portfolio's risk exposure remains in line with the client's risk tolerance and investment objectives.

  • Disciplined Approach: Regular rebalancing promotes a long-term, disciplined investment strategy and prevents emotional decision-making that can lead to poor investment outcomes.

  • Selling Volatility: As discussed earlier, rebalancing can potentially enhance the overall performance of the portfolio.

Conclusion

Robo-advisors have revolutionized the wealth management industry, making it more accessible and cost-effective for a broader range of investors. Their fixed asset allocation strategies and portfolio rebalancing offer numerous benefits, including risk management, a disciplined approach to investing, and the often overlooked advantage of benefits like rebalancing. By regularly rebalancing portfolios, Robo-advisors can help investors capitalize on market fluctuations and potentially enhance their overall investment performance. While the analogy of selling options helps illustrate the concept of indirectly selling volatility, it is crucial to recognize that rebalancing and selling options are distinct activities with different risk profiles and objectives.

Robo-advisors provide a modern, efficient, and accessible solution for investors looking to manage their wealth and are increasingly becoming an attractive option for investors seeking a disciplined, long-term approach to wealth management.


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