Happy New Year…now back to work

Ah, the joys of holiday.  A few notes, to start things off:

1. I couldn’t keep my eyes off markets while away – hopefully this is more a sign that I love what I do, rather than generic neuroticism.
2. My post towards the end of December was shockingly OK with its vague predictions:  oil continues to plumb the depths, SPX had a decent sell off towards the end of December (first negative return in 6 years!!), and I was right to be worried about a long grains position.  I promise not to make many prognostications going forward, as it remains a mug’s game.
3.  I turned off my trading systems for a week, while away at the cold English beach.  Though I would’ve made some decent $$ if I kept on the trends (short oil/nat gas/euro, mainly), I’m much happier to have kept the peace.  Nice to have the Type 2-error feeling, though (i.e. sadness due to lost opportunity, as opposed to sadness due to realised loss).
4. Though late to the game, this week I’ll begin rebalancing my portfolio.  Main theme is (probably) a small shift from US long-only equities towards international equities and alternative equity books.

Glad to be back.

Finance 101: Rebalancing

Let’s talk rebalancing the portfolio.

Most personal finance websites/books/etc. focus a great deal on trade entry; less on trade exit; and usually even less on ongoing maintenance/rebalancing.  Compared with finding ‘the next Google’ or ‘signs to move to cash’, the monthly/yearly rebalance seems pretty boring.  However, rebalancing is very important to a long-only portfolio performance.

Broadly: a long-only portfolio comprising some mix of assets will, over time, become dominated by the best-performing asset.  The usual example is: a mix of equity/bonds will become more and more invested in equities, given their outperformance long-term.  If you don’t rebalance, you are implicitly creating a momentum portfolio – more investment in winners than losers.  While this may have some merit as an idea (I like momentum), the diversification of the portfolio goes into the toilet.  The portfolio becomes a one-way bet on equities.

Harking back to the CFA curriculum, there are a few broad categories of rebalancing:

1. Constant mix – the boilerplate, constant proportions of (say) 60% equities and 40% bonds.
2. Buy-and-hold – the set and forget approach.  Buy on day 1, then never rebalance.  What I’m warning about above.
3. Constant Proportion Portfolio Insurance (CPPI) – Somewhat the opposite of constant mix, this is a fairly explicit momentum strategy.  Equities get an even larger allocation than buy-and-hold as stocks rise.  The kicker is this: CPPI trades off between a ‘risky’ asset (either 100% equities, or maybe a 60/40 portfolio??) and a ‘riskless’ asset (e.g. cash or T-bills).  So the idea is that you put on more risk as risky markets perform well.

When do you rebalance?

1. Time-based – probably the most common approach.  Every month/quarter/year you look at your statement, then rebalance to your target allocation.  For #1 above, you go back to the original 60/40 split (or whichever mix you’ve chosen).  For #3, you use a formula outlined in places like this.
2. Error-based – for those keeping closer attention to the markets: rebalance back to target whenever the realised allocations stray beyond a certain tolerance.

There have been a multitude of research papers written about when is best to rebalance. The trade-off is pretty simple: how much trading cost is incurred, versus the drag induced by not having ‘optimal’ allocations.  From what I’ve read, my opinion is the following:

• Rebalancing is absolutely necessary.  Buy and hold is consistently beaten by rebalanced portfolios.
• However, rebalancing need not be too frequent.  I’ve read the best results from rebalancing no more than quarterly, when holding an all-securities portfolio (NB: if you’re using options, a monthly rebalance is worth the effort).  Annual rebalances are a good rule-of-thumb.

Finally, let’s look at a (somewhat) practical example.  I’ve taken total return series for the S&P 500 and US 10-Year Treasury Notes, from 1998 until end-Oct 2014 (Source: Quandl).  Starting with a 60% S&P and 40% Treasuries, I’ve created 3 portfolios:

1. Buy-and-hold – initial purchase of stocks and bonds remains unchanged throughout the time period.
2. Constant mix – portfolio is rebalanced to 60/40 at the end of each month.  Notice that, over this period, the constant mix slightly outperformed buy-and-hold, despite equities outperforming bonds handily in the period.  We must be capturing some mean-reversion among the two asset classes.
3. CPPI – the portfolio is rebalanced according to the following parameters: multiplier of 3; cushion value (Treasuries used as cushion) of 80.  Rebalance occurs at each month-end.  Notice that this is a much more aggressive rebalancing technique than the others; due to the equity outperformance, especially in the past few years, this ends up being the best relative performer (albeit with much higher volatility).

Which method do you prefer?