Heard of entropy? Never mind. Shall explain.
The entropy of an object is a measure of the amount of energy which is unavailable to do work (second law of thermodynamics). It is a measure of the number of possible arrangements the atoms in a system can have. In this sense, fundamentally, entropy is the degree of disorder.
Nature does a very interesting thing. It always takes low entropy structures and moves them to high entropy. Buildings crumble, structures wear out, ice cubes melt, landscaped gardens go rogue when not maintained, etc.
A pile of sand has high entropy because there are trillions of ways of rearranging the pile, and get the same shape. However, when you create some order, by building a sand castle using a mould instead; it uses the same number of grains, but virtually anything you do to it will mess it up. It’s a much more ordered state, and has low entropy.
If you leave that castle in the desert all day, the winds will blow the sand around and the castle will disintegrate, and fall to bits. Fundamentally, nature is blowing the castle away and making piles elsewhere; and not the other way. The unlikelihood is because there are very few ways of arranging grains of sand to represent a castle.
Entropy in Portfolios
Portfolios are not singular and uniform, but are a collective mix of its constituent parts. Stocks move, and so do mutual funds, and hence do portfolios.
In a fund, where the sole objective of a portfolio is to perform better than the markets and return well to unitholders, the composition of portfolio is carefully monitored for changes on several factors, and are often moulded in a way that it aligns with a strategy.
However, with non-professionals managing their own money, it is common to build a portfolio that serves certain objectives. Over time, as its parts move, the structure of the portfolio changes; its shape and form wear out – often towards a high degree of disorder. Portfolios exhibit a high degree of entropy.
Changes Affect Suitability
Suppose in your portfolio, a stock performs exceedingly well for a year and constitutes to more than 30% of your portfolio (from 10% when bought). You caught some metal companies on the right side of the cycle and they become a sizeable portion of your portfolio.
While these seem like good outcomes, they can have several unfavourable consequences, largely around increased risk, and potential losses. It is necessary to save yourself from the exceptionally well performing stock if it unveils some corporate governance issues and haves in value overnight, or from an international trade war making your stocks come to a fraction of their original value.
You can’t afford for that to happen if you have a major expense coming up next year, or if you’re nearing your 60s and depending on these investments to maintain a certain standard of life. A single-window time frame is definitely avoidable when looking at portfolios, their past performance, their current state and their potential future outcomes.
Assessment and Rebalancing
To avoid situations of misalignment of portfolios with suitability of the investor, it becomes imperative that portfolios are assessed on a regular basis, and rebalanced in order to correct for the deviation.
We assess portfolios regularly, and our systems are built to flag off any inconsistencies and inefficiencies. Other than keeping a check on these, we also continually rebalance portfolios on four parameters:
Change in asset class views or forecasted returns and covariance between asset classes; and change in views on the incorporated factors
Change in views or replacement of instruments within asset classes resulting in a switch of the securities contained in portfolios
The drift that occurs in portfolios because of the movement of asset classes, consequently resulting in an unfavourable mix
Change in investor preferences, risk profiles and goals; which in turn deem a change in the portfolio mix and asset class constitution
Rebalancing Frequency
On a regular basis, we maintain a quarterly rebalance strategy to accommodate for the four parameters determining the need for an adjustment in the portfolio. However, our assessment happens on a continious basis, and is not periodic in nature. Because of the constant checks, reasons for adjustment may even appear in irregular intervals.
Rebalancing for Tax Efficiency
Other than accounting for our rebalancing strategy and other instances which require an adjustment, we also are cognizant of and incorporate a tax loss harvesting strategy. Tax loss harvesting is a simple mechanism of selling any loss-making investments before the tax assessment period (March 31) in order to reduce the total capital gains for the year, and hence reduce the tax payable for our customers.
We implement this by pushing a rebalance update in the last week of March on all loss making investments. This is then readjusted in the first week of April to achieve an optimum portfolio mix again. It may also involve buying the same instruments again, despite them being loss making, if they are the right fit for the portfolio, and the losses are cyclical or short-term in nature, and if our view on the asset classes and underlying instruments hasn't changed.
While this may appear meagre in value, we encourage implementation of this strategy, to cover for some of the costs that our customers incur in the process of portfolio construction and management like advisory fees, brokerage, demat charges, and other costs involved in the buying and selling of securities.
Conclusion
The law of nature implies things move away from a state of order. Portfolios have high or low entropy depending on the cycle the markets are in. Nonetheless, they do tend to disorient, and can result in a suitability deficit. Our investment philosophy recognises this, and accounts for it on a regular basis so that our customers and their portfolios are always well aligned.