Rebalancing, or periodically selling a portfolio’s best performers to buy the worst performers, is the most effective path to an investor’s desired outcome. When a portfolio is initially constructed, an investor targets a level of risk and return through the portfolio’s asset allocation (i.e. stocks, bonds, etc). Rebalancing can help investors maintain an asset allocation that aligns with their needs, goals, and risk tolerance. As the performance of portfolio components varies over time, component weights may deviate from their target allocations, exposing investors to a different risk-return profile than that of the intended allocation. Rebalancing is a tool to manage such deviations.
At Fi3, we have a very disciplined rebalancing process. While we have a somewhat sophisticated approach using tolerance bands that could trigger an intra-year rebalance, the starting point is often a calendar year rebalance during the first 4 months of the year. At the onset of every year, we update our 10-year capital market assumptions, conducted alongside our investment consultant, Fiducient. We utilized these 10-year capital market assumptions to adjust our client portfolios. While many times we only make modest changes to portfolio targets, market action in 2022 was unique. A swift rise in interest rates caused markets to “hit reset” on valuations, which are the largest input into our capital market assumption. This, in turn, resulted in more changes than usual in our portfolio targets. These are summarized below:
Year-over-year we are adding to high quality fixed income primarily by reducing dynamic bonds. As interest rates are beginning to return to historical norms, we can return our fixed income portfolios to a more “normal” allocation. For the prior two years, we utilized a fairly heavy allocation of dynamic bonds in order to play defense against our expectation of rising interest rates. This thesis has played out and we were able to protect capital as dynamic bonds have outperformed core bonds over the past two years.
We are adding Treasury Inflation Protected Securities (TIPS), a financial asset that acts a lot like a real asset. The market is hyper-focused on short-term inflation, yet is seemingly complacent about the prospects for longer-term inflation. With real yields on TIPS at their most attractive levels in some times, an allocation adds relatively inexpensive insurance against long-term inflation running higher than today’s sanguine assumptions.
We are modestly increasing U.S. small cap stocks based on attractive relative valuations compared to their large U.S. counterparts, and in preparation for a possible market rebound.
We are maintaining our slight overweight to Non-U.S. equities, which have compelling valuations compared to U.S. equities. Additionally, should the dollar weaken, this would likely prove to be a tailwind for Non-U.S. equity. Note, however, while we are overweight international equities, we are not adding to these positions due to the greater potential for exogenous events outside of the United States.
As indicated above, we feel there is opportunity within the international markets due to compelling valuations and the potential for a weaker dollar. However, while we tend to utilize a more passive, index approach to U.S. investing, there is room to add an active component to international investing. Therefore, through an extensive research process, we have built a more robust approach to how we invest internationally. Through this work, Fi3 has added several new managers, including for the first time, a dedicated international developed small cap manager. We are excited to add dedicated exposure to this asset class on behalf of our clients as this is one of the least efficient markets that exist in the public space, giving an active manager a ripe opportunity set.
For additional details, please see the brief deck linked here.