Rebalance your portfolio with performance weighting strategy

Being a mutual fund investor, it is very important to balance your portfolio periodically. For this performance weighted strategy is one of the best suited strategy to reap higher returns. In this method, the only factor which is considered is either return on investment or price to earnings ratio. The performance weighted strategy considers that the security with the lower price to earnings ratio as a better buy. Lets look how the strategy works and what are the advantages and disadvantages of the same.

Determining the Price to Earning (P/E)

Determining the price to earnings ratio is bit complicated as it considers the earning per share and the current market price. Analysts and advisors consider various aspects to arrive at the accurate forecasted earnings like revenue drivers, cost centres, operating margins etc. Stocks have different P/E over the period of time that is the trailing and forecasted earnings can be different as per one’s expected earnings. Many investors consider two-year forecasted earnings as well as some of them use trailing for analysis.

Weighting of the fund

Weighting the funds means comparing the funds on the basis of single measure that is performance. Weighting means assigning higher weights to the recent performer and less to poor performer among the basket. After assigning the weightage, investors are expected to adjust the portfolio according to the performance of the fund or the security. Let’s take an example for performance weighting.

Let's say that at year-end 2011 investor started with an equity portfolio of Rs. 1,00,000 across five mutual funds, splitting into equal weightings of 20 per cent each.

After the first year of investing, the portfolio weightages will be changed according to the price movements and returns and will be no more equally weighted at 20 per cent in each fund, as some funds performed better than others.

If we observe the above condition, most of the investor tend to pump in more money into the performing fund and will exit from the non-performing fund even if the time horizon used is shorter to determine the returns. This is not the way to practice performance weighting.

The reality is that after the first year, most of the investors are inclined to dump the Fund D considering it as looser and invest more on winner (Fund A). This however is not what performance weighting is about. It simply means that investors should sell some of the funds that performed good to buy some of the funds that did the worst. But usually our tendency will go against this logic, but it is the right thing to do, because the one constant in investing is that everything is mean reverting.

With the help of performance-weighting strategy, investor can reap more return by periodically rebalancing on the basis of the performance. The strategy of performance weighting is not a 360 degree predictor as the future of the scheme depends upon various other aspects too like fund management style, fund managers, investment objective etc. It cannot be said that the worst performing fund can do well in the coming period. So the strategy lacks in giving indication of the investment accurately. However, it can be used for rebalancing the portfolio as per the investment objective.