Stay on target, Luke Skywalker was urged as he attacked the Death Star. Yet while the Star Wars hero nailed his target, keeping the weightings of different asset classes within their desired ranges can be a tougher challenger for investors than Hollywood might imagine amid constant market turbulence.

Fortunately for Australian investors, the growth of exchange-traded funds has presented more options than ever before in successfully rebalancing a portfolio to maintain its desired asset allocation.

First, some definitions.

Morningstar defines asset allocation as “how your money is divided among different asset classes and investment types, such as stocks, bonds, real estate, commodities, alternatives and cash”.

Putting more money into “risky” assets such as stocks can lead to a higher long-term return, but at the risk of greater volatility compared to lower-risk assets such as cash. Strategic asset allocation (SAA) seeks to balance a portfolio’s risk and return, based on studies that have shown diversification can reduce overall risk for a given level of expected return – described as “the only free lunch in investment”.

For example, an aggressive investor with a long time horizon might have an asset allocation comprising 60 per cent shares, 20 per cent property and 20 per cent bonds and cash.

A more conservative investor with a shorter time horizon might instead be heavily weighted towards fixed income and cash.

Yet solid gains in equities, as seen recently, might result in the share of an investor’s portfolio invested in such “high risk” assets rising above its target range. The art of rebalancing is to reduce such exposure to maintain target allocations, effectively selling more expensive assets and buying cheaper ones.

However, constant rebalancing can result in excessing trading costs, as well as losing the benefit of the capital gains tax discount for assets held longer than 12 months. Yet waiting too long to rebalance can lead to a “regression to the mean” as periods of strong performance are followed by weaker returns.

For these reasons, annual rebalancing is recommended by many advisers, with research suggesting that it can even improve risk-adjusted returns.

Role of ETFs

Morningstar’s Tim Wong, director, manager research, suggests ETFs can play a role in the rebalancing process.

“ETFs offer broad market diversification whenever you need to rebalance to increase or decrease your exposure to different asset classes. Particularly for passively managed ETFs, their management fees tend to be low and there’s also the accessibility of being traded on an exchange,” he says.

“Obviously there are brokerage costs and when you transact more frequently you incur more brokerage, so we’d suggest having a broad eye on the total costs in managing your portfolio, not just the management fee but execution as well”.

Using ETFs to achieve exposure to a particular asset class, such as US equities, also avoids the need to select individual stocks and therefore the risk of choosing the wrong investments, says BetaShares’ David Bassanese.

Morningstar’s ETF model portfolios offer a potential guide in this regard. As at 31 December 2019, its “aggressive” portfolio for investors with a minimum nine-year timeframe had a 45 per cent weighting for international equities and 30 per cent for Australian stocks.

Core holdings included the silver-rated Vanguard MSCI Index International Shares (Hedged) ETF (ASX:VGAD) with an 18 per cent portfolio weighting; the bronze-rated SPDR S&P/ASX200 ETF (ASX:STW) with a 15 per cent weighting; and the silver-rated Magellan Global Equities ETF (ASX:MGE) with a 10 per cent weighting.

In contrast, the “conservative” model portfolio for investors with a minimum two-year timeframe had a 49 per cent weighting for fixed interest and 36 per cent for cash, with just 12 per cent allocated to equities.

Core holdings included the neutral-rated BetaShares Australian High Interest Cash ETF (ASX:AAA) with a 36 per cent portfolio weighting; the silver-rated iShares Core Composite Bond ETF (ASX:IAF) with a 28 per cent weighting; and the bronze-rated Vanguard International Fixed Interest (Hedged) ETF (ASX:VIF) with a 12 per cent weighting.

However, for time-poor investors, Wong points to another option.

“Vanguard, for example, has multi-sector funds that combine its own ETFs in all the broad asset classes, and uses its own SAA. So if investors are OK with the SAA of that product, then that Vanguard fund will do its own rebalancing, so it’s even more hands off,” he says.

In 2019, Morningstar awarded the diversified funds four gold ratings, with analyst Donna Lopata describing them as “an exceptional suite of listed multi-sector strategies”. The funds comprised the Vanguard Diversified High Growth ETF (ASX:VDHG), the Vanguard Diversified Growth ETF (ASX:VDGR), the Vanguard Diversified Balanced ETF (ASX:VDBA) and the Vanguard Diversified Conservative ETF (ASX:VDCO).

“Alternatively, if investors want to be more hands on in applying their own exposure to Australian equities, they may wish to use a single-sector ETF and rebalance accordingly, using individual sector ETFs as their own building blocks for an individual portfolio,” Wong adds.

“The important thing is costs are commensurate – these are low-cost options, not just Vanguard but a lot of these index-tracking options, so cost and convenience are a big plus in their favour”.