Clients may balk, but it's time to re-balance portfolios

Process is hard this year because it involves selling equities to buy (gulp) bonds

Nov 27, 2013 @ 9:58 am

By Jason Kephart

The holiday shopping season kicks off on Friday, but clients may think their financial advisers are buying them a load of coal when they see their quarterly statements. That's because advisers are poised to buy some (gulp) bonds (interest-rate risk included) before the end of the year even though the outlook for stocks is far brighter.

It's part of the annual — semi-annual for some — re-balancing ritual to get client portfolios back in line with their risk tolerance. It hasn't been this hard a process since the financial crisis five years ago, when advisers sold bonds to buy stocks even though it looked like the equities were heading off a cliff.

How to help clients find the right amount of risk for their portfolios

“The biggest hurdle to effective re-balancing is that it's inherently a contrarian strategy,” said Chris Philips, a senior analyst in The Vanguard Group Inc.'s investment strategy group. “You're selling your winners and buying your losers. No one likes to do that.”

In one sense, today's re-balancing is easier than 2008's because stocks are soaring. The S&P 500 index is up a jaw-dropping 28% year-to-date.

“There's no panic today,” said Jane Newton, partner at RegentAtlantic Capital. “Clients are happy, but they're anxious.”

The main cause for anxiety is bonds, which used to be boring and safe. Despite all the talk about stock market bubbles and high share price valuations, there are no dark clouds looming on the horizon for stocks, as there are for bonds.

“The biggest factor clients are worried about today is rising interest rates,” said Molly Balunek, founder of Laurel Tree Advisors.

Bond prices, of course, move in the opposite direction of interest rates and the consensus is that interest rates are more likely to go up than down over the foreseeable future, especially considering that the Federal Reserve may begin slowing down its purchases of 10-year Treasury bills as early as mid-December. To make matters more complicated, there's no mystery over how bonds will react to rising interest rates. The rule of thumb is that for every 100-basis-point rise in the yield on the 10-year Treasury, bonds will lose about 1% of principal. So in an intermediate-term bond fund, with an average duration of four to five years, the loss would be about 4% to 5%.

Still, advisers' plan to stick to their long-term asset allocation was likely thrown out of whack this year by the divergence of stocks and bonds. For example, a client who started the year with a simple 60/40 portfolio comprised of the $287 billion Vanguard Total Stock Market Fund (VTSMX) and the $247 billion Pimco Total Return Fund (PTTAX), the two largest mutual funds in the world, would now have 66.3% invested in stocks and just 33.7% invested in bonds, pushing beyond the typical 5% leeway most advisers give their asset allocation.

With stocks doing so well though, clients might take news of the re-balancing as well as a 5-year-old takes to cough syrup.

“Re-balancing today is not an easy discussion to have,” said John Rafal, founder Essex Financial Services Inc. “Everyone has risk tolerance in an up market.”

The danger in letting that risk tolerance run in an up market is how clients will react if the unexpected happens and stocks tumble 5%, 10% or 15%.

“You shouldn't be dialing up or down your stock allocation based on what's going on in the stock market,” Ms. Newton said. “When the market goes down even a little bit, you can remember why you're in that asset allocation mix.”

Clients aren't the only ones who don't feel completely comfortable moving into bonds, though.

“I've let the equity allocation get to the high end because of anxiety over buying into the fixed-income market,” Ms. Balunek said.

To ease the anxiety, Ms. Balunek has spent the past several months revamping her clients' investment policy statements to better define fixed-income holding parameters. For example, clients now have a specific allocation target to core bonds, global bonds, and floating-rate notes, instead of just “core” and “strategic” bond categories.

“It's a starting point,” she said. “We've let equity stay on the table long enough. Now it's time to pull it back.”


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