The golden rules of rebalancing your mutual fund portfolio

After a few years of investing in mutual funds, investors come face-to-face with two problems. The first is when and how to rebalance their portfolios?

The second is how to clean up their portfolio and reduce the number of schemes.

While you can always try and do these two things independently, let’s try to understand how you can hit both these targets with one stone.

We shall take a simple example to explain this. Suppose you started investing with a 60:40 equity-debt allocation. But after 2-3 good years for equities, your allocation has run up to 74:26. In simple words, the 60 percent of your equity allocation has grown in value, thanks to the growth of markets, and equities now comprise 74 percent of your portfolio.
Also, since you have been investing for several years, you have somehow ended up with 11 equity funds and four debt funds in your portfolio.

As you already know, rebalancing is about reviewing and restoring the originally chosen target asset allocation.

In this case, equity has grown to 74 percent of the portfolio and hence, you may want to bring it back to 60 percent. That means selling 14 percent from equity and putting that money in debt.

There are 3 ways to rebalance:

#1: Periodic rebalancing

This could be done once a year. Some do it half-yearly. But for most, doing it once a year is good enough.

#2: Deviation-based rebalancing

This is triggered if your allocation deviates more than a pre-defined tolerance band. Let’s say the tolerance band is +/-5 percent. So, in a 60-40 scenario, if your portfolio goes below 55 percent or above 65 percent, then it will have to be rebalanced.

#3: Combine the best of both worlds

The third option is to combine the above two. The investor reviews periodically (let’s say half-yearly), but rebalances only when it deviates more than the tolerance band. This is the best option in my view.

Coming back to our example. The portfolio has moved from 60-40 to 74-26 and needs to be rebalanced. Since every portfolio is unique, here are some broad guidelines on how to rebalance your portfolio.

Do you really need so many large-cap funds?

There is enough empirical evidence to suggest that it is getting tougher for large-cap funds to beat their benchmark indices. Take a look at how much you have invested in large-cap funds. And how many such funds you have in your portfolio.

You might want to gradually exit active large-cap funds. It makes sense to have large-cap exposure via index funds only. In any case, most active large-cap and index funds have overlapping portfolios. So, it’s better to gradually get rid of them and just keep 1-2 index funds for large-cap exposure.

Also See: Check out the complete MC30 list of 30 mutual fund schemes

Avoid too many mid- and small-cap funds

The mid- and small-cap space is where active funds are still a good bet. But having too many schemes in these two categories is not necessary. Unless you have a large portfolio, limit yourself to 1-2 funds in each of these two categories. Also, most people don’t need small-cap funds at all, due to its high-risk nature.

Avoid duplicates

One of the biggest reasons to invest in mutual funds is diversification. For as little as Rs 5,000 (the minimum investment in most of the schemes), your mutual fund scheme can diversify across 30-60 stocks. But if you have the same type of mutual fund schemes, e.g., 3-4 flexi-cap funds, you might see the same set of stocks across your portfolios. That’s not good.

Don’t forget your debt funds

Debt funds play just as important a role in your overall portfolio as equity funds. Keep an eye on your debt funds too. Since debt funds grow at a modest rate, they won’t skew your asset allocation as widely as equity funds. But in times like these, when interest rates are rising or nearing their peak, debt funds play an important role in your portfolio. They cushion you when rates fall, as and when the interest rate cycle reverses.

Get rid of the fringe elements

Check the fund’s track record against its own benchmark and peers. If there is consistent underperformance, get rid of it.

Remove funds with 5-7 percent weightage (or less) in your portfolio. These are funds that you may have invested in a while back, or in which you have stopped your Systematic Investment Plans (SIP). Or you may have invested a small ad-hoc amount in the past. These have too small an allocation to impact overall portfolio returns. Get rid of them.

These steps will not only help rebalance your portfolio, but also help cut down the number of funds and reduce clutter.

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