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 September 2010 What's So Wrong with Buy-and-Hold? In at Least This Case, Static Asset Allocation Isn't Much Better
But sometimes the facts simply don't cooperate with what everyone knows. Consider the benefits of a structured asset allocation policy over a mindless buy-and-hold strategy. Modern Portfolio Theory suggests the asset allocation strategy should dominate, and besides, it's just common investing knowledge.
We thought we'd get a good chance to see this at work when we created the two benchmarks for quantitative Portfolio 6. Unlike our other model portfolios that are confined to specific sectors of the market, P6 is free to use both domestic and foreign stocks as well as fixed income. There are some capitalization options and credit quality choices as well. Because it didn't fit neatly into a little stylebox, it was more appropriate to build it a pair of two, custom blended models Model Portfolio 6 started off on January 1, 2004 with with 25% in the Barclay's Capital Aggregate Bond Index, 48% S&P 500, 21% Russell 2000, and 6% MSCI EAFE. Although the Barclay's Capital Intermediate Term Government Bond Index was also an option, the buy-and-hold index did not utilize it because our backtest showed government bonds were not part of the most effective mix. (For details, click here.) P6 would be reoptimized in the first month of each calendar quarter and not only could include government bonds, it might conceivably never return to the original mix. The first benchmark might never return, either, because it would never be reoptimized. It was just the buy-and-hold mix of asset classes initially used for P6. Wherever the market took it was where it would go. The second benchmark was more structured; employing static asset allocation. It started off with the same mix but this would also be its target mix. Whenever P6 was reoptimized, this benchmark would be returned to its original mix if at least one of its asset classes had moved more than 5% away from its target level. If no asset class was more than 5% away from the target, it would be left until the next quarter. This trading rule was included to cut down on turnover resulting from simple market noise.
The Process in Action Given the market volatility over the period, how often would you think the Static benchmark would have been rebalanced? Twice a year? Once a year? More? How about four times? That's essentially once every 20 months or just less than once every two years. Perhaps even more surprising is the fact that the two benchmarks moved in complete tandem for over two years. It wasn't until the rebalancing in April 2006 that they finally diverged. Since then the Static benchmark has been balanced back to the original mix only three more times. As you'll also notice from Chart 1, this hasn't made much of a difference in their price performance. Over the entire period, the difference between the two benchmarks was a mere 4.02%. In absolute terms, the Buy-and-Hold benchmark is up 2.69% while the Static has added 6.71%. A clear win for the Static benchmark, right? Well, maybe not.
To see why, take a look at Chart 2 which shows the annual price returns for both benchmarks. Obviously 2004 and 2005 are identical, but differences appear after that. Although it's difficult to see, the Buy-and-Hold benchmark actually pulled ahead in 2006 and although it was slightly behind the Static benchmark in 2007, it still clung to s slight lead. The greatest annual price divergence occurred in 2008 when the Static benchmark lost 1.25% less than its buy-and-hold counterpart. The overall lead has expanded slightly since then, but it's hard to say either benchmark has dominated the other.
It Actually Makes Sense On the other hand, believers in asset allocation can claim static asset allocation worked as advertised. When it was most needed -- when virtually all investment classes plummeted in 2008 -- it came through. That's precisely when it built the majority of its current lead and it's added to it as volatility rose and investing became more treacherous.
Looking a little closer, the Buy-and-Hold benchmark worked as would be expected. As equities rose from 2004-2007, it held its own against the Static alternative. When the market turned down in the following years, it fell behind given it's swollen equity exposure. Because the two benchmarks diverged in 2006, the Static benchmark was better able to withstand the selling. This, too, is what would have been expected and indeed, is one of the purported benefits of static asset allocation. But why hasn't this been more of a benefit? This is especially true in the first two years of the period when both benchmarks moved in virtual lockstep. The answer may actually have less to do with the benchmarks than with the prevailing market conditions. Both started 2004 with the same mix of only four asset classes. In order for them to diverge, one or more classes would have to substantially outperform or under-perform the others. However, over that period, all equity classes moved up while fixed income held its own. Given the few asset classes involved, it's no wonder the benchmarks moved in tandem. What about the Static benchmark's trading rule? Could it have also hindered the benchmark's ability to move ahead? Without a doubt, it reduced the number of rebalancings, particularly as volatility increased. Then again, that was its purpose. The one thing we know for sure, there were only four times over the past six-plus years when any class in the static mix strayed more than 5% from its original allocation. That actually supports the trading rule rather than calling it into question. Rebalancing based on slight variations adds little to overall performance while increasing the negative impact of trading costs. The benefits of more sensitive rebalancing are at best debatable while the effects of trading costs are certain negatives. The lack of rebalancing through the first two years is reasonable as well. Static allocation is supposed to help the investor buy low and sell high. In a volatile market, it forces the sale of appreciated assets and reinvests in the trailers offering greater opportunity when the trend reverses. This is precisely what happened when volatility increased from late 2007 through the end of the period. On the other hand, static asset allocation can actually work against an investor in trending markets. Because it forces the sale of appreciating assets and reinvestment in the laggards, it stunts the potential benefits of letting winners run. This is what occurred in the first three years of the period. As stocks moved up, it followed along with the Buy-and-Hold benchmark. When it was finally rebalanced in 2006, it sold winning equities and reinvested in trailing fixed income. The equity rally continued through 2007 working against the Static benchmark's relative performance over that period.
Something for Everyone Buy-and-hold advocates can take comfort in the fact that static allocation didn't leave them in the dust. In fact, the 4% difference over six-plus years is rather minimal. Depending on trading costs, it could easily be wiped out, particularly if market volatility remains high and more frequent Static benchmark rebalancing is required. Maybe buy-and-hold isn't the joke some make of it. On the other hand, the Static benchmark is essentially working as predicted. It's trading rule is holding down trading costs and at last through August 20, 2010, it's established a lead over its buy-and-hold counterpart. What more can you ask? One last thing to keep in mind to put all of this in context is the fact that P6 itself, the dynamic allocation based on forward-looking market and economic assumptions -- has left both well behind. (Click here for the current cumulative comparison.) This is perhaps the best support for those who believe active dynamic asset allocation can actually add value over more passive approaches whether they be static asset allocation or simple buy-and-hold. Yes, there's something here for everyone. Search this site! Just enter you key word or words: Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
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ERTAIN THINGS ARE JUST UNDERSTOOD to be true. Investors would never question the value of buying low and selling high. No one doubts there is a relation between risk and return. No one but the most naive really believes buy-and-hold is a valid investing strategy. Everyone just knows this.
