James Surowiecki’s The Wisdom of Crowds makes a strong case for thinking that large groups of people are generally smarter than even the most intelligent few. The “wisdom” manifests itself in many ways, including price discovery, which is why indexing is such a competitive force in money management. A new research paper seems to reconfirm this point via the broad ebb and flow of mutual fund results. But on closer inspection, there’s an intriguing nuance in this study that raises questions about whether investors generally are taking advantage of rebalancing’s rewards.
“We find that fund investors alter the riskiness of their portfolios in response to shifting economic conditions, increasing risk as the economy improves and reducing risk in anticipation of economic downturns,” advises “The Wisdom of Crowds: Mutual Fund Investors’ Aggregate Asset Allocation Decisions,” by professors John Chalmers, Aditya Kaul and Blake Phillips. In other words, investors overall make timely decisions in managing asset allocation. This is what you’d expect to find if markets are efficient, although the paper’s results conflict with other lines of research that document a history of improving returns with some simple techniques, as I discuss in my book, Dynamic Asset Allocation.
The evidence in favor of rebalancing is quite strong. In fact, one recent study explains that the crowd’s reluctance or inability to adjust asset allocation in a timely manner is a key reason why a minority of investors can exploit the rebalancing bonus. There’s also a few studies that show that many investors hardly change the portfolio mix at all over long periods of time. It all seems to make sense in the context of rebalancing. Excess returns, after all, are a zero sum game and so winners must be financed by the losers. The idea here is that the many leave alpha on the table, which allows a relative few to reap the rewards.
Yet the new paper by Chalmers, et al. seems to contradict this idea. “Our evidence suggests that mutual fund investors collectively respond to the information in forward-looking financial variables,” they write. If the crowd overall is wise, that pokes a hole in the concept that there’s a rebalancing bonus that can be exploited by the few. But Chalmers and his co-authors also note that their results are skewed a bit in favor of “sophisticated investors.” As they explain,
We study whether the relation between the predictive economic variables
and flows varies across investor profiles. Using fund expense ratios and portfolio turnover as proxies for mutual fund investor sophistication, we find that the allocations of
sophisticated investors are more sensitive to changes in economic conditions, and account
for a large part of the relation between economy-wide flow and economic conditions. In
contrast, the relation between flow for funds held by unsophisticated investors and
economic conditions is much weaker.
Perhaps this new paper on the wisdom of crowd’s doesn’t overturn existing research on rebalancing after all. Common sense tells us that everyone can’t be above average, even if everyone thinks otherwise.
But what does all this say about market efficiency? Surprisingly, perhaps, it’s not necessarily a stake in the heart for the efficient market hypothesis (EMH). Rebalancing can improve returns and/or lower portfolio volatility, which seems to violate EMH. But while there’s no increase in volatility (usually) with rebalancing, there’s an increase in other risk measures. That starts with the recognition that rebalancing relies on reversion to mean as an asset pricing factor. This is a well-established empirical fact, but mean reversion can’t be counted on like clockwork. There are also transaction costs to consider. And successfully rebalancing demands a fairly robust commitment to being a contrarian, which history shows is the exception to the rule for most investors.
There’s also a separate point worth noting. Traditional active management in the aggregate can’t beat indexing, a concept that also applies to multi-asset class investing, i.e., asset allocation. But that’s independent to some degree of recognizing that systematic rebalancing is likely to enhance results for an otherwise identical portfolio that’s unrebalanced.
The rebalancing bonus isn’t a free lunch and most investors can’t earn it, at least not in sizable quantities. But over the long haul, that’s not a repudiation of the crowd’s wisdom. Then again, wisdom isn’t always conspicuous in the short term, nor is it always obvious when looking ahead in real time. History, of course, is quite clear: It’s still tough to beat the market, even when you rebalance. That doesn’t mean you should mindlessly buy and hold. But don’t expect alpha to fall out of trees either.