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Envestnet Warns Against Letting Winners Run

By Murray Coleman April 27, 2016

When markets rally, some advisors choose to let their winners run. But that might be a big mistake over the long term.

At least that’s what researchers at Chicago-based investment outsourcer Envestnet are warning. The turnkey asset manager, which manages about $93 billion, has completed a study on how advisors using its platform made out rebalancing client portfolios during different time periods.

In good times and bad, results were remarkably similar, Jay Hummel, Envestnet’s head of strategic consulting, tells FA-IQ.

“Our research clearly shows that rebalancing is as important during market upturns as during downturns,” he says.

For decades academic research has trumpeted the value of rebalancing. But such studies have largely been forced to rely on industry surveys and other types of indirect approximations to mimic investment behavior, says Hummel.

By contrast, Envestnet says it’s tapping directly into data from a network that includes more than 47,000 U.S. advisors.

“Our research in effect is trying to bridge the gap between theoretical outcomes and actual documented behavior by advisors on behalf of their clients,” says Hummel.

The results were taken from two distinct periods – 2007-2009 and 2014-2015. The first represents a period of global financial crisis and the last charts a timeframe when markets were recovering.

In both cases Hummel and his team found that a disciplined plan of rebalancing produced on average about a 0.5% annual increased return over advisors who didn’t rebalance for their clients.

These conclusions, he points out, closely track a previous Envestnet study. That earlier report, sent to clients two years ago, covered a 30-year period and used strictly traditional academic research methods. It found an almost 0.45% upside over the longer-term for those who regularly rebalanced.

Advisor Matt Papazian, chief investment officer at Denver-based Cardan Capital Partners, has been following Envestnet’s latest studies. His practice, which manages about $520 million, now uses the investment outsourcer’s trading platform.

“This fresh research provides more convincing evidence that rebalancing isn’t just a strategy that advisors need to follow when markets are getting crushed – it can work just as well during periods when stocks are doing quite well,” says Papazian.

But more than just tending to smooth out returns over extended market cycles, the longtime advisor – whose practice broke away late last year after 26 years at Merrill Lynch – believes such a study reinforces the need to use rebalancing as a risk-management tool.

“Over a few months there might be a benefit to letting winners run – but over longer periods those advantages clearly start to dissipate,” says Papazian. At the same time, he adds, “any temporary gains actually can work against your clients’ longer-term needs to shield their portfolios from greater exposure to market volatility.”

Jay Hummel

Papazian says he sticks religiously to a yearly schedule of aligning clients’ overall stock allocations to their proper proportional weights as called for in each individual’s investment plan. But he also considers whether long-term valuations of different equities and fixed-income indexes have changed notably. His team also keeps their eyes open for any signs of recession.

“While we’ve developed our own review process, other advisors commonly create minimum and maximum bands around different asset classes to guide their rebalancing,” says Papazian. Whatever those refinements might be, he adds, “they should be designed to complement and reinforce to clients your main strategy of selling high and buying low.”

An overly complex rebalancing strategy could prove counterproductive in handling client behavior, says Jim Pratt-Heaney, founding partner at LLBH Private Wealth Management in Westport, Conn.

“We tell our clients from the beginning that rebalancing is the key to executing a successful financial plan – we try not to let our discussions drift into whether markets are temporarily up or down,” says Pratt-Heaney, whose firm manages about $1.7 billion and uses Envestnet’s client-reporting and fund research platforms.

He has also closely monitored the investment outsourcer’s recent studies on rebalancing as well as those published by leading academics over the past several years.

Despite his best efforts, Pratt-Heaney admits some investors still ask about letting winning stocks run during strong market rallies.

“But we take those conversations as clear signals that we need to spend more time on educating those clients about our investment process,” he says.

If that fails, his staff has drafted a letter that it sends out to individuals who decide to invest against any advisor’s rebalancing recommendations.

“We feel like it’s our responsibility as fiduciaries to make sure people clearly understand that by letting their portfolios become overly concentrated in certain parts of the market,” says Pratt-Heaney, “they’re taking on more risk than we feel is necessary to reach their long-term financial goals.”