August 15, 2011
An Old Debate, A Familiar Response
Is the rebalancing bonus a myth? A number of readers told me so after I briefly mentioned the concept last week. The charge that rebalancing isn't guaranteed to deliver a performance premium over the same portfolio that's left to wander is, of course, true. Much depends on when and how you rebalance, along with the composition of your portfolio. But this caveat isn't terribly surprising, nor is it particularly helpful in the cause of looking for productive strategies in money management. There are no sure things in finance, for the simple reason that the future's uncertain. Even "cash" comes with a sliver of risk.
Recognizing rebalancing's imperfections as an excuse for dismissing the idea is short-sighted in the extreme. To paraphrase Tolstoy, every investment strategy is flawed in its own way. Understanding why rebalancing is flawed is essential, but it's hardly a basis for snubbing the strategy. Indeed, if you're looking for the ideal methodology, you're destined for disappointment. The question, then, is deciding how to prioritize the infinite possibilities for managing the investment challenge?
A growing body of research and real-world track records suggest that the key building blocks of intelligent investment design begin with asset allocation and rebalancing. That's not necessarily the end of the journey, although for many investors it very well could be and, arguably, should be. But regardless of whether this is a stepping stone or a destination, there's a strong case for seeing these twin pillars as money management's foundation. You can amend, revise and adjust these strategies to fit your unique circumstances and talents. But rejecting them outright is almost always a mistake.
I'm defining asset allocation here in simple but broad terms. By purchasing a broad mix of the major asset classes, you're diversifying far and wide. This is a risk-management tool at its core. If we have confidence that stocks will beat bonds over some period going forward, or vice versa, or that REITs will best commodities, etc., then there's a case for leaning heavily on one asset class at the expense of the others. But absent a view, a forecast, a guess--the default asset allocation is simply holding a market-value weighted mix of everything. As it turns out, a simple buy-and-hold strategy that's diversified broadly tends to deliver competitive returns on a risk adjusted basis, as theory advises and market history generally confirms.
Rebalancing a broad mix of assets is no less compelling for a number of reasons, ranging from risk management improvement to the possibility of boosting raw performance numbers. There are no guarantees, of course, but that's no shock, nor should it be a reason to abandon the fundamental proposition that diversifying across asset classes and keeping the allocations from going off the deep end is a reasonable goal with modest benefits. Even better, you don't have to work very hard to reap the rewards.
Critics are quick to point out the limits of asset allocation and rebalancing, charging, for instance, that there are times when either one will deliver subpar results. That's true, of course, and it's important to recognize this possibility. But it could hardly be otherwise. If you stop for a minute and think about it, every strategy faces the hazard that it can and will stumble from time to time. If rebalancing was a sure thing, the world would pile in and the expected return from the strategy would quickly fall to zero, at best.
The reality is that asset allocation and rebalancing are used unevenly in the grand scheme of investing. Many investors ignore or reject these concepts outright. For those who do pay the strategies lip service, the execution is often messy. All of which lays the groundwork for a minority of investors to benefit handsomely from asset allocation and rebalancing. As a number of studies suggest, the failures of the many tend to finance the rewards of the few in matters of investing, and rebalancing is no different.
My post last week was a simple observation that the recent surge in volatility among the major asset classes was a sign that rebalancing opportunities were unusually ripe once again. But as sure as night follows day, the greater opportunities were accompanied with greater risk, some of which is self inflicted by way of inaction.
Ok, asset allocation and rebalancing are flawed, we're told. So, now what? The superior alternative is….? Yes, there are many possibilities. But all paths ultimately come back to the question: What do the numbers tell us?
A simple strategy of holding all the major asset classes in their market weights and rebalancing the mix every December 31 is demonstrably competitive, as I've discussed several times. What's more, this simple strategy, as defined by my Global Market Index (GMI), has proven to be above-average vs. 1000-plus multi-asset class mutual funds, as I noted earlier in the year. Part of the reason is that you replicate GMI for 50 basis points or less via ETFs and ETNs--well below what many actively managed strategies charge. If active managers always delivered big helpings of alpha, the higher costs would be worthwhile. But that's not the case, of course, and so low expenses usually provide a big edge. Another advantage in holding everything and rebalancing the mix every so often is that it minimizes the danger that surprises in the future will trip up the best laid plans of mice and men. Once again, that's proven to be a huge stumbling block for maintaining superior returns by trying to outwit the crowd.
For those who prefer a model-free approach to asset allocation, there's more good news in the sense that equal-weighting everything, and rebalancing to maintain that equality, seems to do even better than cap weighting. But even this boost isn't immune to improvement, or so fans of fundamental weighting assert.
Yes, you can improve upon a simple asset allocation/rebalancing strategy. But you can also do worse. The world is eager to emphasize the former, and to quick to overlook the latter.
Posted by jp at August 15, 2011 7:41 AM
Well, I can't control how people think, but I can suggest that investors make a distinction between tactical asset allocation (trading based on making forecasts) and rebalancing (keeping allocations based on pre-set parameters in a forecast-free context). You can do one, or both, or neither, of course. And you can argue for other strategies as well. There are no free lunches with any of these choices, or doing nothing for that matter. All entail risk of one form or nother. Pick your poision. For most folks, owning a broad mix of assets and rebalancing it semi-frequently is compelling.
Posted by: JP at August 16, 2011 12:00 PM
Once a year or even twice a year, but I don't think that's what "rebalancing" means to most investment folks. I think it is perceived to be something much closer to trading. Hence, when they hear that rebalancing is a better strategy, I think it is heard as "trading is a better strategy".
Posted by: mg at August 16, 2011 10:46 AM
Yes, it's true: taxes complicate the analysis for all investing strategies. Of course, if we're talking of tax-deferred accounts, there's no problem. In any case, it's never wise to underestimate the impact of taxes, along with trading costs. These surely take a bite. The question is when are the costs of rebalancing outweighed by the hazards of a hands-off risk management policy, which you seem to be suggesting. Eventually, the risk-reward tradeoff in favor of rebalancing becomes compelling. The real debate, then, is how often to rebalance? Once a year? Once every other year? Or let the asset allocation changes dictate frequency? The answer varies on the investor, the portfolio, the tax bracket, etc. But the argument to do nothing, if that's what you're suggesting, has limits... eventually.
Posted by: JP at August 16, 2011 9:16 AM
I don't think your analysis includes questions of taxation and how more rebalancing and trading affect taxable investors. In short, a short-term gain of 20% annualized taxed at 40% (average federal + state income tax) is equivalent to a gain of 15% through long-term gains, taxed at 20%, on an after tax basis. Both strategies keep 12% gains after taxes.
Hence, the short-term strategy has to come up with 500 bps of extra return to compete with the long-term strategy. In light of this, I don't see how re-balancing makes sense to an investor with a reasonable time horizon.
Posted by: mg at August 15, 2011 2:35 PM