Sunday, July 09, 2006

Asset allocation basics: Part VII Rebalancing

In this post, we continue the series on asset allocation after a long hiatus. At this turbulent time in the market, it behooves us to visit the topic of rebalancing.I’m going to assume that my readers have a basic understanding of rebalancing, i.e. the process by which the original asset weighting is reclaimed after various asset classes have appreciated/depreciated at different rates for some time. When the on-going contribution is large in relation to the portfolio, it can be most easily done by overweighing the contribution towards the “laggards”. Otherwise, it may be necessary to sell the overweighed asset classes to purchase the underweighed ones. The best guideline on when to rebalance that I’ve seen is provided by the Radical Guides.

… the correct question may not be “How often should I rebalance?”, but rather “How far should I allow my asset classes to stray from their target allocations before I rebalance?”. Rebalancing only when an asset class reaches 150% of the target allocation, for example, will perhaps result in a more tax efficient and more profitable portfolio.

Consider also this gem:

Here’s one intriguing rebalancing variation to consider. If an asset-class allocation reaches 150% of your original allocation, don’t just cut it back to the target allocation. Instead, cut it back to below the target allocation - say 75% of your target allocation. If that asset class then falls to 50% of your original allocation, restore it to 150% of the original allocation.

The rationale is as follows. If one asset class is appreciating much faster than the others in your portfolio, you want to ride the momentum to 150% of your target allocation. But when you are ready to trim back the asset class, it’s probably become overvalued relative to your other assets. So sell more of it than would be required to return to your “normal” asset allocation. Similarly, if the asset class then depreciates significantly, it has probably become cheap relative to other asset classes, in which case you can overweight it.

The rest of the guide on asset allocation is sure worth a read as well.

As is often the case, knowing the right thing to do does not automatically lead to actually doing it. I intend this article to be a call to action, if you will, by demonstrating the need to rebalance, as opposed to “let the winners run” or any other excuse for inaction. A concrete example would be the small cap/large cap differential – some of you may be aware that small caps have outperformed large caps in the past six years. In addition, I want to comment on an interesting article on capitalization weighted indices.

Think in circles, not straight lines

It’s a quirk of human nature that our minds tend to extrapolate things linearly both in space and time, perhaps due to our limited sphere of perception in both domains. It took some exploration to convince people that the earth is round – a fact that is widely accepted nowadays (Flat Earthers notwithstanding). Unfortunately, the same cannot be said for the cyclic nature of human history. Somewhere between “history rhymes” and “if we don’t learn from history we are doomed to repeat it” lies a recurring ignorance and hubris. The best example is the theories popping up at times of prosperity, of why it is so richly deserved and how it will last for ever. In financial markets, the same mentality leads legions of investors to confuse luck with skill as they chase the hot sectors of the day. The lack of humility ultimately proves their undoing as they stay in those sectors way to long after they peak.

It is far beyond the scope of this article to discuss business cycles, mean reversion, and financial forecasting. But a plain record of historical returns from various asset classes may suffice. The chart below from US Global Funds (I own their precious metal and resource funds, UNWPX and PSPFX) lists the returns of their mutual funds for the past decade in descending order. The funds are color coded to help visualizing their changing fortunes. The lack of performance persistency is quite striking. Unless you have a reliable forecasting method to determine which fund will perform the best in the coming year (in which case, please write to me), the most effortless way to capture this performance rotation is periodic rebalancing.

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
China Average 24.8% Large Cap Growth 26.4% Large Cap Growth 32.3% Global Em. Markets 70.7% Muni Inter-Term 9.2% Gold & PM 18.8% Gold & PM 63.0% China Average 64.3% Energy & Materials 26% Energy & Materials 38.93%
Energy & Materials 22.8% Energy & Materials 20.2% Mid Cap Growth 18.3% China Average 69.2% Energy & Materials 6.3% Muni Short-Term 4.8% Muni Inter-Term 8.3% Gold & PM 60.7% Global Em. Markets 24.0% Global Em. Markets 31.60%
Large Cap Growth 20.1% Small Cap Growth 17.9% Small Cap Growth 6.6% Small Cap Growth 67.1% Money Market Gov. Only 5.8% Muni Inter-Term 4.4% Muni Short-Term Global Em. Markets 55.4% International Equity 19.5% Gold & PM 30.40%
Small Cap Growth 17.9% Mid Cap Growth 17.5% Muni Inter-Term 5.4% Mid Cap Growth 63.2% Muni Short-Term 5.3% Money Market Gov. Only 3.6% Money Market Gov. Only 1.3% Small Cap Growth 44.2% Mid Cap Growth 12.9% International Equity 14.53%
Mid Cap Growth 16.8% Muni Inter-Term 7.5% Money Market Gov. Only 5.1% International Equity 53.2% Mid Cap Growth -4.8% Global Em. Markets -3.0% Global Em. Markets -5.8% International Equity 41.3% Small Cap Growth 11.3% Mid Cap Growth 9.60%
Global Em. Markets 14.4% Money Market Gov. Only 5.1% International Equity 4.8% Large Cap Growth 36.8% Small Cap Growth -5.6% Energy & Materials -6.2% Energy & Materials -9.5% Mid Cap Growth 36.0% China Average 8.6% China Average 7.89%
International Equity 13.9% Muni Short-Term 5.0% Muni Short-Term 4.6% Energy & Materials 20.8% Large Cap Growth -12.9% China Average -8.5% International Equity -13.6% Energy & Materials 29.3% Large Cap Growth 7.3% Small Cap Growth 6.35%
Gold & PM 11.5% International Equity 2.9% Energy & Materials -1.4% Gold & PM 6.1% China Average -14.2% Small Cap Growth -10.4% China Average -14.1% Large Cap Growth 28.1% Muni Inter-Term 2.8% Large Cap Growth 5.96%
Money Market Gov. Only 5.0% Global Em. Markets -1.6% Gold & PM -10.5% Money Market Gov. Only 4.6% Gold & PM -16.7% International Equity -16.8% Large Cap Growth -27.0% Muni Inter-Term 4.1% Muni Short-Term 1.0% Money Market Gov. Only 2.65%
Muni Short-Term 4.0% China Average -23.9% China Average -16.2% Muni Short-Term 1.4% International Equity -17.1 Mid Cap Growth -21.4% Mid Cap Growth -27.4% Muni Short-Term 2.1% Money Market Gov. Only 0.8% Muni Inter-Term 2.32%
Muni Inter-Term 3.4% Gold & PM -41.8% Global Em. Markets -26.1% Muni Inter-Term -2.4% Global Em. Markets -29.7% Large Cap Growth -21.7% Small Cap Growth -29.1% Money Market Gov. Only 0.6% Gold & PM -8.3% Muni Short-Term 1.23%

Large and small capitalization stocks
If you had small cap stocks in your portfolio in the past five to six years, you must be quite happy with how they have contributed to your returns. However, now is a good time to rebalance the portfolio if you haven’t done so recently. The over performance of small cap stocks has been mentioned in previous installments of this series, especially in the discussion on asset allocation derived from Paul Merriman, index investing and the Fama-French three factor model. Small cap stocks have NOT always outperformed larger ones as seen in the multi year ratio chart of Russell 2000/S&P 500 below. Indeed, prior to 1999 there was a 5 year period of things leaning the opposite way. Small cap stocks do outperform if one goes further back in history, a la Fama-French and may continue to do so in the future given enough time. But the question of how well the long term averages derived from 70-100 years of market history apples to a limited investment time horizon is a real and crucial one. 5-years may be a significant time with respect to many investors’ time horizon. In an environment of rising interest rates and input (read commodity and labor) prices, small cap stocks may not do well compared with larger cap, dividend paying stocks for some time going forward.

John Hussman, manager the Hussman Strategic Growth fund (HSGFX, a hedged mutual fund which we own), is one of the most brilliant financial minds today. In one of his recent missives, he outlined the change in P/E of the 500 stocks in the S&P relative to their capitalization from 2000 to 2006, and concluded that the smaller cap stocks have experienced greater P/E multiple expansion:

Median Price/Earnings Ratios for S&P 500 Stocks
Market CapMarch 2000March 2006
Top 5035.617.3
Top 10030.818.1
Top 250 22.918.3
Bottom 25012.918.8
Bottom 10011.519.8
Bottom 5010.120.3

This data strongly suggests that valuation rather than pure performance was behind the gains made by the smaller cap stocks. Since valuation is cyclical, as the cycle turns smaller cap stocks will fall relative to larger ones. The data above alone does not suggest small cap stocks will start to lag behind larger cap ones, but the concerns based on interest rates (borrowing cost) are well warranted.

This is not a call to eliminate small cap stocks in your asset allocation, just as it was problematic to jump full-force into small cap stocks after 5-6 years of over performance. This is not even a call to reduce the allocation to small cap stocks going forward. Rather, if you’ve had some small cap stocks for some time chances are they have made large relative gains, and now would be a good time to pare back some if you missed the opportunity two months ago.

The problem with indexes
This is a digression from the topic at hand, but an intriguing one if you’re interested in the cutting edges of index investing. John Mauldin’s Investor’s Insight is one of the best free sites for financial information. He brings to the readers not only his own illuminating writing, but that of other leading thinkers as well. In the article titled “Problem with indexes” he brought forth this idea from Rob Arnott:

… what winds up happening is that every asset is trading above or below true fair value. We can't know what true fair value is. But we can know that every stock, every asset, every bond is going to be trading above or below what its ultimate true fair value is. Even the most ardent fans of the efficient markets hypothesis would say, "That's reasonable. That's reality."

Now if every asset is trading above or below its true fair value, then any index that is capitalization-weighted (price-weighted or valuation-weighted) is automatically going to have us overexposed to every single asset that's trading above its true fair value and underexposed to every single asset that's trading below its true fair value.

You should read the above paragraphs a couple times and let them sink in. Note that most indices including the Dow, S&P and Russell are cap-weighted. Now let’s continue:

… now while it's a bad index, equal weighting will outperform a cap-weighted index. [Equal weighting means that you put the same amount of money in a stock, no matter what its capitalization or share price.] A lot of folks think that equal-weighted indexes outperform mainstream capitalization indexes because they have a small-stock bias. The theory being that small companies beat large because they have a value bias, and cheap stocks outperform expensive ones. That's not quite correct. What equal weighting does is underweight every stock that's large, regardless of whether it's cheap or dear, and overweight every stock that's small, regardless whether it's cheap or dear.

This means that from a valuation perspective every stock that's overvalued is overweight in the cap-weighted index, and in the equal-weighted index it's a crap shoot, 50/50. You have even odds, whether it's overvalued or undervalued, of being over- or underweight.

The above paragraphs were of particular interest to me as I used the RSP (Rydex equal weight S&P index ETF) vs. SPY example in Part V of this series. Let's take a look at the long term ratio chart of RSP/S&P 500 first:

In the Russell 2000/S&P 500 chart shown earlier, 1994 and 2006 were at roughly the same level, i.e., cap size effect alone would imply the same returns for RSP and the S&P 500 from 1994 to 2006; however, the chart above clearly tells a different story. By rough eyeballing I can tell that RSP/S&P is well described by a linear combination of Russell 2000/S&P and a positive sloping line which has to come from the more precise index weighting of RSP as Rob Arnott pointed out.

That was pretty neat. But there is more. Jeremy Siegel (author of Stocks for the Long Run) was quoted in the same Mauldin article:

With the advent of fundamental indexes, we're at the brink of a huge paradigm shift. The chinks in the armor of the efficient market hypothesis have grown too large to be ignored. No longer can advisers claim that capitalization-weighted indexes afford investors the best risk and return tradeoff. The noisy market hypothesis, which makes the simple yet convincing claim that the prices of securities often change in ways that are unrelated to fundamentals, is a much better description of reality and offers a simple explanation for why value-based investing beats the market.

So there you have it, the latest word on index investing. The snub given to the Efficient Market Hypothesis is quite interesting – the “fundamental indexes” are clearly products of fundamental analysis which the semi-strong form of EMH disavows. But active managers should not rejoice too soon, “fundamental indexing” is still a kind of passive, broad-based strategy with mechanical rules that require little subsequent intervention. Although I don’t know for sure, “Fundamental indexing” may well be the same principle preached by Dimensional Fund Advisors. Certain products from PowerShares may take advantage of that philosophy as well. If you are aware of any products based on this “fundamental indexing” please leave a comment.

< Part VI

I’m not a registered investment advisor and the above should be taken as for informational and educational purposes only. You should consult a professional before making any financial decisions based on information from this site.