Tuesday, October 5, 2010

Using Rebalancing To Take Advantage of Asset Fluctuations

It has been well documented that returns for asset classes fluctuate due to the presence of bubbles and anti-bubbles. This presents opportunities for investors to use techniques like rebalancing to take advantage of these fluctuations. See the following post from The Capital Spectator.

Jason Zweig at The Wall Street Journal warns that the bond market is in a bubble. He may be right. Or not. It’s always hard to tell when bubbles are lurking. That doesn’t mean we shouldn’t try, but we need to be wary of going off the deep end too.

If we’re defining a bond bubble by low yields in the fixed-income market—Treasuries, in particular—there’s surely some substance to the bubble talk. Yields have almost never been lower. The path of least resistance, then, is up for yields. But when? Will interest rates start rising next week? Or next year, or five years from now?

Even when bubbles seem to be a clear and present danger, investing doesn’t necessarily get any easier, so the perennial dominance of mediocre returns suggest. But hope springs eternal, and sometimes for good reasons. If you accept the conventional wisdom among financial analysts in recent years, the markets have been plagued with a series of bubbles over the last generation in different asset classes. Of course, if we’ve been beset with bubbles, we must also have had periods when the opposite was true—anti-bubbles, or periods when asset prices are inexpensive. Looking back on it all, it must have been true that it was easy to boost investment results. Unfortunately, if you looked at returns earned by investors over the past decade, the results aren't often inspiring.

Yet in theory, bubbles and anti-bubbles should be an investor’s best friend. The presence of these peaks and valleys suggests that expected returns are below average (or above average for anti-bubbles). In fact, financial economists have been documenting for a few decades that expected return (and realized return) fluctuate for asset classes. Bubbles and anti-bubbles are part of the reason why. The problem is that returns also vary for another reason: few investors are able to take advantage of these fluctuations.

A number of studies over the years remind that most investors do a poor job of rebalancing, either because they wait too long to pounce after large price changes, or by not rebalancing at all. Because most investors don’t manage the asset allocation of their portfolios in a timely manner, the expected risk premiums linked to asset allocation are that much higher for those who are willing and able to act relatively quickly.

If everyone was dynamically managing their portfolios with great skill, the performance boost that appears to be related to opportunistic rebalancing would be smaller, perhaps even falling to zero. But don’t hold your breath. It’s hard for most folks to act when opportunity is at or near a peak. Why? For all the obvious reasons, of course. How many investors were buying stocks in late 2008? Or selling stocks in late 2009?

Studying history inspires thinking that we should focus on exploiting bubbles and anti-bubbles. Those points, after all, are where the low-hanging fruit prevails. But it should come as no surprise to learn that most investors, institutional or otherwise, end up with average results.

That’s partly due to the fact that cashing in on higher expected return takes lots of discipline. That’s because the biggest opportunities are usually associated with making contrarian decisions. There's a risk premium for embracing hazards at times when most people are running in the opposite extreme. In fact, you would expect no less in an efficient market. The only reason to buy stocks in late 2008, for instance, is that the expected risk premium is higher than normal. Why is it higher than normal? Because late 2008 was a period of extreme uncertainty and macro risk. Thus, investors needed to be compensated appropriately for wading into the market.

But there’s also the problem of uncertainty. Even if you’re a contrarian’s contrarian, you still don’t know what’s going to happen tomorrow, next week, next year. Bubbles and anti-bubbles can remain in those states for long periods of time. Not always, but enough to keep the crowd guessing… and making mistakes.

Taking advantage of fluctuations in expected return, in other words, is tough. Assuming, of course, that you’re trying.

It helps if you’re a financial whiz, but even a know-nothing investor can juice returns a bit. In my newsletter I regularly analyze several versions of a value-weighted index portfolio of all the major asset classes. One of the insights is that mindless rebalancing has added 50 to 100 basis points for this index over time vs. the passive version that does nothing other than initial setting asset allocation to market-based weights and letting the mix run. It's not a sure thing, of course, but it looks durable, especially over several business cycles for a broadly diversified portfolio.

Consider, for instance, that the fully passive Global Market Index has earned an annualized 4.4% for the past 10 years through the end of last month. The strategy that generated that result was simply holding all the major asset classes in their respective market-value weights and letting the financial tide manage the mix. The same strategy that was rebalanced every December 31 did a little better, earning 5.3% over that span. And if you equal weighted everything and rebalanced every December 31 to maintain equality, the trailing 10-year return surged to 8.4%.

In fact, if your investing talents are above average, you can do even better. But don’t forget that there’s always risk lurking. The presence of bubbles and anti-bubbles certainly contribute to the broad array of risks that bedevil investors’ best laid plans, and theoretically offer opportunity. But the uncertainty of deciding if this is (or isn’t) a timely moment to exploit bubbles and anti-bubbles is a risk too. Ditto for the question of whether we’re able to accurately assess if we’re even in a bubble or not.

There’s a wide assortment of avenues for beating a multi-asset class benchmark that makes no attempt to time markets or pick asset classes or individual securities. But there’s no shortage of pitfalls either.

Over time, most investors will have a hard time beating a passive mix that owns everything. That’s no surprise, since excess returns are funded by below-average returns, and losses. That simple mathematical truth inspires a deep round of self analysis for deciding if you think you have what it takes to make above-average investment decisions for the rest of you investing life. Most investors think they’re in the above-average category. The fact that so many are wrong in thinking that is why there’s opportunity for the relative few who truly reside in that exclusive club.

This post has been republished from James Picerno's blog, The Capital Spectator.
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