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  • Asset allocation: Rebalancing

    Posted by ML on November 16th, 2006

    This installment in the series on asset allocation deals with rebalancing.

    Basic premise
    The basic premise of is simple. After setting in motion a particular allocation plan, the asset classes would have appreciated/depreciated at different rates, such that the resulting allocation may deviate far from the original. Rebalancing is simply the process by which the original weighting is reclaimed. When the on-going contribution is large in relation to the portfolio, it can be most easily done by overweighting the contribution towards the “laggards”. Otherwise, it may be necessary to sell the overweighted asset classes to purchase the underweighted ones.

    The best guideline on when to rebalance that I’ve seen is from 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.

    Rebalancing runs counter to one of the most cherished trading rules, “let the winners run.” Instead, the winner is (partially) cut short to feed the laggards. Philosophically, there are two assumptions here that are the quintessential of passive investing:

    1. Leadership in asset classes rotate, in other words, trees don’t grow to the sky.
    2. It is not possible to consistently predict which asset class will be leading at any one time. Alternatively, you may say the passive investor does not attempt to predict which asset class will be leading.

    Rotating leadership
    One perfect example of the rotating leadership is seen in the 10 year performance map from US Global Funds (I own their UNWPX and PSPFX). The funds are color-coded and arranged in order of returns in each year. There is no discernible pattern in this map so the annual performances appear random. Therefore, a passive investor who maintains a fixed exposure to each sector year in and year out. A good analogy is: an allocation plan + rebalancing is to individual sectors as an index fund is to individual stocks — and you know how actively managed mutual funds compare with index funds.


    Click to enlarge

    Small vs. large cap stocks
    The second example I want to discuss is the craze of small cap stocks in the past five years. 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 lifted 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 mix and the Fama-French three factor model.

    However, 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 applies 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 I own), is one of the more 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 Cap March 2000 March 2006
    Top 50 35.6 17.3
    Top 100 30.8 18.1
    Top 250 22.9 18.3
    Bottom 250 12.9 18.8
    Bottom 100 11.5 19.8
    Bottom 50 10.1 20.3

    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. Indeed, small and mid caps have not managed to surpass their May highs whereas the Dow and S&P have done so convincingly.

    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 before May.

    As always, this is not investment advice, please do your own due diligence before making any financial decisions.


    More related posts:
  • Asset allocation: Introduction
  • Asset allocation: Index investing

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