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 November 2004 Stuck Together
That’s also why even the most meticulously balanced portfolio eventually needs rebalancing. As soon as it begins to trade, each of its various components reacts differently, leaving a different mix. If you’re a buy-and-hold investor, this really doesn’t matter, you simply let your holdings move as they will. But if you pay attention to asset allocation it’s an important consideration. As results diverge, you’ll eventually need to rebalance. It’s an ongoing process.
Rebalancing is an important issue for Portfolio 6 since it relies almost completely on dynamic asset allocation for its return. When we introduced P6, we wanted to measure it against an appropriate index. Individual equity or fixed income indexes are limited to single classes and couldn’t adequately reflect its multi-class approach. Instead, they needed to be combined. We decided to compare P6 to two such indexes. Actually, we only created one with the expectation that it would diverge into two. So far (through the end of August) that hasn’t happened. . The PlanP6 is designed to be an asset allocation portfolio an individual investor could use with minimum trading and expense. Like P5, it’s based on exchange traded funds (ETFs) representing broad asset classes.Since it’s designed for an individual investor, its performance should be compared to benchmarks representing typical investors’ portfolios. We settled on two: Buy-and-hold and static asset allocation.
The buy-and-hold approach is the one most often used by individual investors -- whether they know it or not. Essentially it’s just what the name says: buy a collection of investments and then simply hold them for the long-term. No trading or rebalancing is needed and the assets are allowed to run as they will. The second approach, static asset allocation, is more structured. Here the investor sets target percentages for each asset class and then periodically rebalances the resulting mix back to them. This approach is gaining popularity with financial planners and individuals handling their own 401(k) investments. To create benchmarks we devised a relatively conservative asset allocation that could appeal to the average investor. This mix would be the static benchmark. If, at the end of any calendar quarter any component diverged by 5% or more from its initial percentage, the entire portfolio would be rebalanced back to the original mix. That’s how static asset allocation works. To capture the buy-and-hold approach, we planned to also allow the original mix to run without rebalancing. Like the buy-and-hold investor’s portfolio, this benchmark would never be rebalanced. We expected this benchmark to emerge from the original static asset allocation at the end of the first calendar quarter at which point it would be tracked separately. The Unexpected ResultsWe were wrong. In fact, we’ve been wrong through the first eight months of the year and may be even longer.It’s not that the different asset classes traded in lockstep -- they didn’t. Chart 1 shows the path followed by the static benchmark’s five components through the first eight months of 2004. There was a lot of movement, especially the more volatile equity series.
Chart 1 may suggest the static benchmark was volatile, too, but it wasn’t. The simple fact that the component series bounced around doesn’t necessarily mean the overall portfolio did. Indeed, if you look closely at Chart 1, you'll notice that while all classes fluctuated, only the EAFE Index of foreign stocks moved by more than 5% in either (actually both) directions. And with only a 6% initial weighting, it had minimal effect. The other thing to notice notice from Chart 1 is the way movements in the various asset classes offset one another. This is particularly evident in the April-June period where losses in the S&P 500 and Lehman Brothers Aggregate were more than offset by gains in the EAFE and Russell 2000. This illustrates how the proper combination of risky assets can smooth the overall return. As a result, through August, the P6 static benchmark moved in a fairly tight range bounded by a gain of 4.1% and a loss of 2.3% (Chart 2). This is a much tighter range than those of the individual components as shown on Chart 1. Also notice that the general pattern of returns in Chart 1 matches closely with that of the overall benchmark in Chart 2. All classes and the benchmark start the year with positive returns, yet all fall back by April and have remained relatively flat ever since.
This is the most telling reason behind the continuing convergence of the buy-and-hold and static benchmarks: If all asset classes are generally following the same pattern, their weightings in the overall portfolio will remain relatively unchanged. That's exactly what's happened here. Chart 3 shows the percentage weightings for the static benchmark's individual components. Despite the market fluctuations of the first eight months of the year, they've remained remarkably consistent. None have come anywhere close to moving 5% from their initial weight. So it's no wonder the static benchmark hasn't had to be rebalanced in 2004. The component weightings haven't changed. Until they do, the two benchmarks will remain stuck together.
The ReasonIt will take a trending market before any rebalancing will be required. So far, that hasn't happened this year. Neither stocks nor bonds have been able to establish any lasting momentum. Foreign stocks, represented by the EAFE Index, have the least correlation with domestic securities and as shown on Chart 1, have experienced the greatest fluctuations. Even so, Chart 3 shows what little impact there was on its relative weight.Following the equity run in the late 1990s and the bear market of the early 2000s, 2004 has been quiet and directionless. There's nothing abnormal about that, in fact it's to be expected as markets consolidate following the runs of the previous decade. As many individual investors learned at the end of the bull market, trading for trading's sake is not a good long-term strategy. The same is true for the static benchmark. With no major trends requiring response, it's essentially a buy-and-hold portfolio. That's not an underlying weakness, but rather the effect of a trendless market. P6 itself is a dynamic model, attempting to capitalize on changing market and economic conditions. Such models usually underperform their static counterparts in trendless markets. As of August 31, P6 was 0.60% ahead of the benchmarks. To that point, it has been as much as 1.53% ahead and 1.13% behind, basically what you'd expect in such an environment. Eventually a trend will develop -- either up or down. When that happens, P6's two benchmarks will finally uncouple. It's not the purpose of the model to decide when this will happen, only to be prepared when it does. At that point, P6 will truly have two benchmarks. Search this site! Just enter you key word or words:
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NE OF THE FEW THINGS INVESTORS know with any degree of certainty is that all assets perform differently. That's why diversification can smooth portfolio returns while it's not a good idea to own just one stock or bond or whatever.
