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Does Market Volatility Mean It's Time to Rebalance Your Portfolio?

The past three months have been a wild ride for the markets. The Chicago Board Options Exchange Volatility Index, commonly known as the VIX, is up more than 100% year to date.

For advisors, volatility may offer an opportunity to rebalance client accounts and get them back to predetermined allocations.

If a client's risk tolerance, time horizon and other factors make a portfolio of 60% stocks and 40% bonds the best choice.

As a simple illustration, say the advisor and client together determined that 20% of the total equity holding should consist of large-cap stocks. Over time, these stocks decline in price and now constitute only 15% of the total portfolio. An advisor may assess other areas of the portfolio that have gained in value, and pare positions that grew beyond the determined allocation. The proceeds are then invested into underperformers.

Some advisors rebalance as needed, and others on a predetermined basis, such as quarterly or every six months.

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Volatile Markets

Rebalancing is not necessarily as straightforward as it sounds. Volatile markets, by definition, change rapidly. Advisors don't want to be reactive and make unnecessary changes to client holdings, even if clients become anxious.

"It is always difficult during volatile markets and recessions. It doesn't help that this was not your typical recession, and it came with unprecedented volatility," says Bryan Ward, partner and chief investment officer at ProCore Advisors in Newport Beach, California. "Of course we structure portfolios around clients' long- or short-term goals. But that does not mean we should just hold and ride things out."

"We have been able to take advantage of offsetting capital gains with recent short-term losses," he adds. "We are continuing to maintain high-quality stocks with good balance sheets."

Ward says his clients' portfolios were overweighted in the health care and technology sectors at the beginning of 2020, which helped maintain positive returns or very minimal losses so far this year. Those two sectors performed well, even during the broad market downturn.

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"Though we have increased cash holdings and are slowly adding companies that have been more affected by the shutdown," he adds. "That said, we are not in a real rush to reinvest the cash we have raised in accounts."

Ward attributes that caution to almost universal expectations for dismal second-quarter economic data, along with uncertainty about the timing of an eventual market recovery. "We still feel there will be plenty of time to take advantage of some sectors like travel and leisure in the second half of the year," he says.

Market Neutral Approach

Dave Clott, senior portfolio manager at Westwood Holdings Group in Dallas, is a proponent of what's called a "market neutral" approach.

''Market-neutral income is an alternative strategy with the potential to deliver low-risk, uncorrelated returns to traditional as well as nontraditional portfolios," he explains.

By uncorrelated, Clott is referring to the way price movements of one asset correspond with another. As the broadest example, stocks and bonds, in many market conditions, have low correlation.

In other words, asset classes that usually show low-correlation are now more highly-correlated. For that reason, Westwood is guiding clients toward new ways of looking at low-correlation within a portfolio, using nontraditional instruments and strategies.

[Read: Managing Portfolios: The Upside of Structured ETFs.]

Clott believes a market-neutral approach, including arbitrage and global convertible bonds, offer an attractive opportunity for credit investors who demand low correlation to both equities and traditional credit allocations.

Advisors are accustomed to using quantitative analysis when evaluating and rebalancing portfolios. The concept of including assets with low correlations is a well-established tenet of portfolio construction, whether practitioners call it a market-neutral approach, or simply refer to it as asset allocation.

Market volatility may present a chance to add to positions where advisors see strength, or to rotate out of weaker sectors or asset classes.

Loreen Gilbert, president at WealthWise Financial Services in Irvine, California, says her firm likes the consumer staples, technology and health care sectors. To mitigate the risk of tech and health care, her firm is adding consumer staples stocks. That sector includes companies that make items consumers use regardless of economic conditions, such as personal care or household cleaning products. The sector is less likely to fall completely out of favor, even during a steep economic or market decline.

Sticking to the Game Plan

Retirement investors must also face the real possibility of reduced spending power if inflation rears its head. Equities have historically been a hedge against inflation. However, investors who fear the inherent volatility of equity markets can put their retirement at risk by owning too little stock.

"When there's uncertainty, some might see cash as the safest play," says Sally Cholewka, director of financial planning services at America Group Retirement Strategy Centers in Southfield, Michigan.

"However, ignoring the possibility of future inflation , and excessively retreating to the safety of cash is, in itself, also a risk to client portfolios," she adds. "Cash positions held over long-term time horizons have historically resulted in loss of purchasing power because interest rates on cash tend to lag inflation."

Investors who hold onto their diversified positions and stay the course are less likely to encounter market-timing risk, experts say.

Cholewka says it's too early to know how client portfolios may need to be rebalanced later this year.

"We recommend establishing rules for rebalancing in advance and sticking to the plan," she says. "Asset allocations are based on individual risk tolerance and time horizons, not on market predictions. No reason to get out the crystal ball. We'll just wait to see if rebalancing is warranted."

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