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It's time for a tricky year-end portfolio balancing act

High wire act risk
Chung Sung-Jun | Getty Images

The start of the final quarter of the year means it's time for portfolio rebalancing — but you better know how to do it. And it doesn't mean simply selling winners and buying losers. Rebalancing is an act that can bring out the best — and worst — from investors. A presidential election and Federal Reserve on the verge of an important interest rate hike before year-end may make the rebalancing act even trickier than it usually is.

As the year winds down many investors will sell investments that have posted big gains and buy those that seem poised for future growth, or maybe because they appear as relative bargains based on recent underperformance. Consider energy, leading the way among S&P 500 sectors, up more than 20 percent. Energy seems like the perfect example of why a beaten-down sector is the right buy at year-end: in 2015, the energy sector was down by 21 percent.

But Larry Swedroe, director of research at financial advisory network BAM Alliance, cautioned against trying to beat the market with a sector rotation strategy. "There is no evidence that investors are likely to benefit from sector rotation strategies," he said. "If it was true then we would see active managers persistently outperforming. But not only is that not the case but the evidence is that fewer and fewer active investors are beating their appropriate risk-adjusted benchmarks every year."

"Trying to do this stuff is playing what [Charles Ellis, founder of Greenwich Associates and author of "Winning the Loser's Game"] Ellis called the 'Loser's Game,' meaning it was possible to win but the odds of succeeding were so low that it's a fool's game," he added.

Don't play the loser's game

Swedroe said the most important thing to remember is that regardless of the season, cheap tends to outperform what is expensive — that means what is selling at low prices to metrics like book value, cash flow and earnings outperforms what is selling at high prices relative to those metrics. And also a focus on inexpensive index funds. Rebalancing periodically is OK as long as an investor does not confuse it with the thinking that sector rotation will be a winning strategy over the long-term.

There is a big debate now, said Mitch Goldberg, president of investment advisory firm ClientFirst Strategy, about whether portfolio rebalancing should be tactical or periodic.

Tactical means based on criteria such as how much a holding rises or falls and how quickly, and based on macroeconomic or other factors. That may not be what an "index purist" considers true passive-investing, but Goldberg said if an investor uses a strict set of rules to trigger any buying or selling, then the investor can be sure the decision-making process isn't driven by emotions.

Periodic rebalancing is also rules-based, and very simple to understand and implement — it is strictly based on pre-set times, such as the end of a calendar quarter or year.

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Goldberg said index pundits can gripe about rebalancing morphing into market-timing, but that requires a belief that passive investing is only buying and holding mutual funds and ETFs, and never looking or changing anything.

Rebalancing the right way

The ultimate success factor is sticking with an approach, not thinking the only acceptable approach is being buy and hold forever.

"It is when investors jump ship to another strategy they lag," Goldberg said. "Many index purists can say'you would've been better off in an index fund that you didn't touch because in a straight-up seven-year-old bull, indexing has worked out incredibly well. "But nothing breeds more ignorance, complacency, and validation of one's intelligence than a winning hand."

So rebalancing the right way means sticking to a pre-determined set of rules. And importantly, it also means designing a set of rules based on your risk tolerance, regardless of how a particular sector has performed in the year. "The discipline to change your allocations based on your original allocation is more important than the actual allocation itself in many cases," Goldberg said. "It's called rebalancing. But it's hardest when a holding is performing well; investors hate leaving a good party, but the hangover isn't worth it."

Say the technology sector has done so well it's become 25 percent of an investor's portfolio. For many investors that's going to be a huge red flag. Conventional wisdom dictates a stock or sector should be no more than five to 10 percent of an individual's portfolio. But Goldberg said, "No one fits the conventional mold perfectly." The lower one's risk tolerance, the less of an allocation there should be for each stock or sector, and the more a portfolio should be diversified by adding more holdings.

"If you're more daring, you could be more concentrated in sectors and just hold them for long stretches of time. But you have to be the kind of investor who is at ease with big swings in your portfolio," he said.

"Nothing breeds more ignorance, complacency, and validation of one's intelligence than a winning hand." -Mitch Goldberg, president of ClientFirst Strategy

Once an investor understands how to rebalance, it's OK to look at how the sectors have fared — but only then.

Four S&P 500 sectors in addition to energy all up double-digits this year: utilities, telecom, tech and industrials. Consumer discretionary, health care and financial sectors have been laggards.

"Energy and utilities have done well year-to-date, but we have concerns about their performance going forward," said Todd Rosenbluth, director of mutual fund and ETF research at CFRA. He noted that even after the big rebound the energy sector faces challenges from low commodity prices. Utilities, meanwhile, have been among the sectors to most benefit from the low interest rate environment, which has driven investors to seek income from dividend-paying stocks.

Should rates rise — and the market does expect the Fed to raise after its December meeting based on the current CME Fed Watch measure, with 63 percent of traders preparing for a hike — investors may shift back to more growth-orientated stocks, Rosenbluth said.

Rosenbluth sees better opportunities in 2016 laggard consumer discretionary and technology.

"Tech stocks have done well this year, and we think they'll continue doing well so long as the economy shows strength," he said. "Within the consumer discretionary sector, we see equity that is attractively priced. This sector has underperformed but it usually does well in the fourth quarter due to holiday shopping. It would also get a boost from a general economic rebound. On top of this, consumer discretionary isn't terribly interest-rate sensitive, so a rate increase should not greatly affect it," Rosenbluth said.


2016 sector performance snapshot

ETF
YTD performance (%)
1-year performance (%)
Quarter-to-date performance (%)
Energy Select Sector 21.2 7 1.6
Utilities Select Sector 12.5 12.3 (-3)
Industrial Select Sector 10.5 10.4 (-1.3)
Materials Select Sector 10 9 (-1.3)
Consumer Staples Select Sector 5.5 8.5 (-1.7)
Health Care Select Sector 1.4 7 0.1
Technology Select Sector 13.5 0.4 18
Consumer Discretionary Select Sector 3.3 4.4 (-0.2)
Financial Select Sector 3.6 7 2.2

(Source: XTF.com, data as of 10/11)

Other laggards among sectors may also see gains.

"If I had to speculate I could see health care and financial ETFs getting a boost sometime during the first half of 2017," said Sumit Roy, analyst at ETF.com.

"Health care, in particular, may get a boost once the headline risk of the presidential election is removed later this year. Meanwhile, financials may see an uptick once the Fed hikes rates in December and signals that more hikes could be forthcoming," Roy said.

The ETF.com analyst said investors should be cautious on energy. Valuations in the sector are high and reflect oil prices much higher than current prices. "Additionally, OPEC will have difficulty implementing (September's) agreed production cut, while U.S. output may begin to rise as U.S. producers begin to drill again," Roy said.


In the short-term, some of the big sector winners that have benefited from the search for yield may continue to due well. Expect more volatility in the coming weeks as the presidential election approaches and earnings season picks up pace, said Neena Mishra, director of ETF research at Zacks Investment Research.

"The market has priced in a Clinton victory and we'll likely see a broader market sell-off if the race gets tighter," she said, though recent polling suggests Clinton's lead is growing. "However, I don't think the outcome of the election would have a long-term impact on the market. After the initial reaction, the direction of the market would be determined more by the strength of the economy and the Fed's actions."

She said money may move back into defensive sectors such as utilities until there is better visibility. But she doesn't expect the sector to rally as strongly as it did earlier in 2016 and she's bearish on utilities in the longer-term.

"The Fed has made it quite clear now that they're not going to keep rates low for much longer now," she said. "Apart from increased probability of a rate hike by the Fed in its December meeting, I'm concerned about overextended valuation."

As as result, Mishra's most comfortable recommending the technology and health care sectors in 2017.

2016 sector flows snapshot

ETF
Quarter-to-date flows
YTD flows
1-year flows
Energy Select Sector $559M $1.6B $2.6B
Utilities Select Sector $37M $959M $101M
Industrial Select Sector (-$54M) $675M (-$324M)
Materials Select Sector $0 $542M $492M
Consumer Staples Select Sector $222M $410M $628M
Health Care Select Sector $324M (-$932M) (-$1B)
Technology Select Sector $159M (-$1.7B) (-$154)
Consumer Discretionary Select Sector (-$73M) (-$2.1B) (-$1.5B)
Financial Select Sector $289M (-$4.1B) (-$2.5B)

(Source: XTF.com, data as of 10/11)

Analysts generally are most optimistic on the health care, technology, and consumer discretionary sectors, said John Butters, senior earnings analyst at FactSet. "These three sectors have the highest percentage of buy ratings: 55 percent, 54 percent, and 51 percent, respectively.

However an investor chooses to rebalance, Goldberg said it's asking for trouble if the rationale is "sell high and buy low."

"It's not quite as simple as just selling a winner and buying a loser because, as we know, winners and losers could stay that way for some time," Goldberg said. He does recommend rebalancing at least once annually to keep funds from becoming over- or under-represented in a portfolio.

Goldberg doesn't recommend trying to time the market based on the Fed. A big rate increase might make dividend-paying investments such as utilities, REITs and telecom less attractive, but few investors see a big rate hike in the near future, he said. "If rates went up a quarter-point, it'll be a non-event," Goldberg said.

—By Joe D'Allegro, special to CNBC.com