Bubbles, Rebalancing and Asset Allocation

Remember the bond bubble? This is the prediction that bonds are subject to irrational exuberance and so they’re vulnerable to a crash any day now. Analysts have been warning that the end is near for several years. Meantime, the rally rolls on.

The Vanguard Total Bond Market ETF (BND), for instance, is comfortably in the black for the past year through May 21, posting a 7.2% total return. For the past three years, BND is up 6.7%.
Bonds may be in a bubble, of course… or not. It’s hard to know for sure until after the fact. That’s no excuse for ignoring valuation or going through the critical process of projecting expected return and risk. But much of the way the bubble talk is presented is impractical if not dangerous from a strategic-minded investing perspective.
It’s easy to get worked up about dramatic talk of bubbles and the potential for crashes. But it’s far from easy to exploit these types of forecasts. That’s obvious by reviewing the audited performance numbers of investment portfolios generally. One example that’s a regular topic on these pages is the persistence of above-average returns with passive asset allocation strategies. As I discussed last week, history shows that it’s hard to beat a portfolio that mindlessly holds all the major asset classes. A bit of simple, periodic rebalancing has a habit of juicing returns a bit more. The result: most of the mutual funds that engage in multi-asset class investing of one form or another have trailed simple asset allocation benchmarks over the past 10 years.
Hold on, say the critics, haven’t we learned that bubbles are a fact of life in the markets? Haven’t we learned the hard lesson from 2008 that markets crash and that buy and hold is for suckers? Whether you think the answers to these and related questions are “yes” or “no” doesn’t change the fact that broad diversification across asset classes and regular (or semi-regular) rebalancing exploits the lion’s share of what you need to know about investing. That includes dealing with the potential for bubbles.
Rebalancing, after all, is a tool for hedging bubble risk in a world where the timing of bubble bursting is a perennial mystery. For instance, let’s say you ignored the bubble forecasts of recent years and continued to hold a portion of your portfolio in bonds. In that case, your bond allocation is probably above the target weight for the portfolio—perhaps substantially above the target. In other words, it’s time to rebalance: sell some of the bond holdings and rebalance into other asset classes that haven’t performed as strongly.
It’s all quite simple, of course. More importantly, it works. Granted, there’s no guarantee that the underlying markets you own will earn a positive return, particularly in the short term. But that variable is beyond the control of mortal investors. Asset allocation and rebalancing, by contrast, are within our grasp.
Even so, relatively few investors (even among professionals) do a good job of exploiting the rebalancing bonus, as the chart I posted last week reminds. There are many theories about why so few investors cash in on this simple but effective strategy. Some of the explanation is related to a bias for poorly designed asset allocation strategies. In order to earn a rebalancing bonus, you need to hold a broad array of asset classes, perhaps to the point of dividing up the major pieces into a number of subcategories. You’ll also need to adopt an aggressive contrarian mindset to fully take advantage of the opportunities. Think buying equities in December 2008, for instance, or paring bond allocations now.
It’s also likely that many investors suffer from managing overly complicated investment strategies. Simple is often better when it comes to harvesting risk premia through time. Unfortunately, that’s a lesson that’s too often ignored or dismissed, despite decades of research that tell us otherwise.
Don’t despair, however. Although most investors do a poor job of exploiting the rebalancing bonus, that means that the expected returns from this task are that much higher for everyone else who focuses like a laser beam of optimizing the decisions here.
Rebalancing alpha, like all alphas, inevitably sums to zero and so the winners are financed by the losers. This simple but powerful point isn’t widely understood, but it ends up driving quite a bit of the performance results for investment portfolios the world over. For the minority of investors who are taking advantage of this insight, there’s probably a secret hope that the rest of the crowd doesn’t catch on. If history’s a guide, there’s no reason to fear. A relatively small share of investors will probably earn most of the rebalancing bonus over the long haul. The only question is whether you want to be in the minority?