A reader wants to know which mutual fund he should use for rebalancing – outperformers or underperformers in a portfolio—a discussion.
The primary objective of portfolio rebalancing is risk reduction. We remove some funds from an asset class performing well and shift it to another asset class. Typically this is done from equity to fixed income or vice versa.
So investors must be ready to redeem funds doing well. On the other hand, funds with a loss can be used for the rebalance to save on some tax.
I assume the question pertains to equity to fixed income rebalance, and underperformers here are in a relative sense, and there is no capital loss.
If a rebalance is necessary, the equity market has done well, and if all equity funds in the portfolio have done well, there is no issue. All of them can be equally redeemed for the rebalance. Redeem means removing whatever is necessary to reset the portfolio to the desired asset allocation.
If there are some underperformers, we will have to find out what kind of equity portfolio it is. We can classify them in three ways.
- Cluttered portfolio with many funds in the same category
- A mix of active funds and passive funds
- A slim portfolio with only active funds or only passive funds.
Now how do you call a fund an underperformer?
If a mid cap fund is not doing so well compared to a large cap fund, will you call that an underperformer? Or do you call it diversification? The same arguments hold for Nifty 50 vs Nifty Next 50 or any comparison between funds of different categories. Remember, the most important tenet of diversification is that not all holdings will perform equally well.
We cannot look at the current performance and conclude only the outperformers are necessary for diversification. That trend may not last long.
If your portfolio is well-diversified with distinctly different holdings, comparing their returns for rebalancing does not make sense. We recommend using all holding equally for rebalancing.
If your portfolio is cluttered with many funds in the same categories or many funds with significant portfolios overall, use the rebalancing to trim off some funds.
If your portfolio has a mix of active and passive funds, and some active funds, have not consistently beat the index, get rid of them fully/partially with the rebalance.
Gradually investors will soon recognise that as long as they appreciate the importance of portfolio rebalancing and have decided to go for it, which fund they pick – underperformer or outperformer – does not matter much. The only thing that matters is accumulating a corpus for our future expenses. Also see: How to systematically reduce risk in your investment portfolio.
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