ETFs and January Rebalancing

Coming off such a dismal 2008, it is tempting to simply bury your head in the sand, keep the money under the mattress, and come back up for air in 2010, hoping we have turned the corner. Of course, in reality, we know this is not the best course of action. In fact, market history tells us that the market experiences significant rallies in the 5 years after a market bottom, with returns of around 15% vs. 10%. So if you want to participate, but are still cautious, one way is by taking advantage of low-cost ETFs and the annual rebalancing that occurs in January for many target-date and target-year funds.

Though not all such funds utilize ETFs, many do, and they tend to stick to the lower-cost “vanilla” variety like DIA, QQQQ, MDY, SPY on the equity side, and TLT, AGG, SHY for bonds. While these are certainly all very liquid names, a large influx of cash (especially into the equity ETFs) can certainly bid up the prices. Also, note that most of these are trading at a small discount to NAV currently; increased demand may shrink this gap and even create a premium, though probably not too substantial, again given the liquidity and transparency of these investments. The rebalance “factor” is certainly no guarantee, but since equities fell more than bonds in 2008, funds with fixed allocations to equities will have to sell off bond positions to reestablish their targeted equity allocation. Maybe just a glimmer, and short-lived, but it is something that may get us through January to at least alleviate some of the pain of the last few months.

Disclosure: no positions

Comments

[Cameron James:]

Very insightful, and undoubtedly true, but I wonder if the "average" investor could take advantage of this. Seems to me you would need quite a large position to make a few basis points. Again, though, it is intuitive, and it will be interesting to see how the premium/discount changes on these ETFs

Jan 15 10:11 AM