Investment Perspectives: Are diversification & rebalancing key to a prosperous portfolio?

09 Oct 2023

Investment Perspectives: Are diversification & rebalancing key to a prosperous portfolio?

Over the last 5 years, when it comes to growth and value, there have been two very distinct periods. Growth stocks have dominated since the Global Financial Crisis, but over the last 3 years, since Pfizer Monday in November 2020 when the first vaccine candidate against Covid-19 achieved success, value stocks have edged into the spotlight. Growth stocks generally do better when interest rates are low and are expected to stay low and value stocks tend to come to the fore when rates rise.


What’s diversification and rebalancing got to do with it? Diversification means lowering your risk by spreading money across, and within different asset classes, such as stocks, bonds, and cash, reducing the risk if one asset or market performs poorly and providing protection from market ups and downs while maintaining growth potential. Diversification can increase returns by exposing investors to different assets and markets that may perform well at different times. Portfolio rebalancing helps us to book the profit when a market is high and average our investments when a market is low, increasing returns by using market volatility. No matter what the economic backdrop or which type of stock is in favour, diversification and rebalancing are fundamental to a successful portfolio.

Put your money where your mouth is springs to mind! So, we’ve done a little experiment using 12 data points to prove the benefits. All of the RSMR Rated funds in the IA UK All Companies sector were screened for their correlation to growth and value indices. From this group of Rated funds 10 were selected, 5 with the highest correlation to growth and 5 with the highest correlation to value, excluding passive vehicles and index plus funds. The comparative index fund was chosen on the basis that it was the RSMR Rated passive with the lowest tracking error compared to its benchmark, with the final data point being the sector average return.

The review period chosen was the 5 years ending 22 September 2023, or more specifically the 260 weeks ending on this date. Year 1 refers to the first 52 weeks in this period, year 2 to the following 52 weeks, and so on. To explore the supposed benefit of diversification and portfolio rebalancing, the two groups of five were then used to create 25 pair-wise combinations, one value and one growth, with a 50/50 split between the two funds, creating 25 mini portfolios and at the beginning of each year, the mini portfolios were rebalanced back to the 50/50 split.

On average, the 10 selected funds outperformed the passive comparator 50% of the time in each individual year and outperformed the sector average performance 64% of the time. So, each year on average, 5 funds would beat the index and 5 would underperform. In years 1 and 2, all the value funds underperformed the passive comparator, and all the growth funds outperformed the passive comparator. In years 3, 4, and 5 it was pretty much the opposite. This change in market leadership is the core reason for diversification. For the 25 mini portfolios, 70% outperformed the sector average in each individual year, and 56% outperformed the passive comparator. This is only a small increase, but the real power comes from the cumulative effect.

Over the full 5-year period, the cumulative performance of the ten funds was also split so that 50% of the funds outperformed the passive comparator and 50% underperformed, but interestingly, 90% of the funds outperformed the sector average over the full period, with only one fund underperforming. How can we improve these odds?

When we look at the mini portfolios, all 25 outperformed the sector average for the full 5-year period which isn’t unexpected given that all but one of the funds outperformed the sector average over this time. The more interesting finding is that 18 of the mini portfolios, representing 72% of the sample, outperformed the comparator index. So, we’ve gone from having 50% of the funds outperforming to 72% of these mini portfolios outperforming. Even stripping out the rebalancing effect, if none of the mini portfolios were rebalanced, 64% of them outperformed the passive comparator. So, the diversification on its own increased the chances of outperforming by circa 14%, and diversification plus rebalancing increased the odds by 22%.

The average cumulative return for the 10 active funds over the 5-year period was 24.5% whereas it was 26.6% for the mini portfolios, giving an average uplift of 2.1%. The difference between the top performing fund and the bottom performing fund in the sample group was 41.9% whereas the largest difference in performance for the mini portfolios was 34.7%, giving a much more consistent outcome for the blend.

There was some logic applied when choosing the funds, and the funds are rated by RSMR so we’re confident in their ability to outperform, but the selection process other than this was a relatively random exercise. The assets within the sample are all from the same sector and the same geography, so they have a relatively high correlation to each other. The power of diversification and rebalancing is even more evident when you utilise assets with very low or even negative correlations. What does this tell us? If you can add together the power of diversification, rebalancing, and some skill in tilting the portfolios towards the more favourable funds at the right times, outperformance is eminently possible.

So, what are we saying here? If you have high conviction and select a single option which is very different from peers and the benchmark, you could outperform by a significant margin if you are right but this cuts both ways and you could be wrong by a catastrophic margin.

By owning multiple assets that perform differently, you reduce the overall risk of your portfolio so that no single investment can hurt you too much, while concurrently improving your potential returns and stabilising your results. Rebalancing effectively restores the original weighting in a portfolio by buying and selling individual assets, bringing the relationship between risk and return into balance. So basically, it’s a no brainer, if you’re in the business of managing risk and maximising returns, you’ll be all over a diversified, rebalanced portfolio.

Richard O'Sullivan, Investment Research Manager

Katie Poulson, Client Engagement & Marketing Manager


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This information is for UK Professional Advisers only and should not be given to retail clients.The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

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