Rebalancing Portfolio Enhanced By Efficient Frontier Analysis

by: Lowell Herr

Whether one is a passive or active investor, one of the most difficult decisions, when constructing a portfolio, is to know what percentage of the portfolio to invest in a particular asset class or market sector. The first table shown below is the Strategic Asset Allocation plan of a sample portfolio. Asset classes with the purple background are under target and those with the red background hold percentages above the target threshold. Threshold limits are set for 20% in this portfolio.

The question remains, is this an adequate Strategic Asset Allocation plan or is it possible to develop a better asset allocation plan? Further analysis using the Efficient Frontier provides additional guidance in setting up an improved asset allocation model. See the second slide.

The assumed growth of the market was set to 6.5% for this analysis. Constraints were placed on the major asset classes as well as individual ETFs. The Return/Volatility ratio for the existing portfolio is identified by the diamond marker on the graph. Further up the Efficient Frontier curve is the optimized portfolio. The Return is approximately 100 basis points higher and the Volatility also increases.

The following table is used to rank the holdings based on three and six month holding periods. Fifty percent (50%) of the ranking weight is tied to the most recent three months performance, 30% to the momentum over the past six months, and 20% to volatility. Low volatility receives a higher rank.

The top five ranking ETFs are: VTV, VOE, VBR, VTI, and DVY. It is not surprising that the first three are value oriented ETFs.

The column on the far right shows the momentum for each asset in the portfolio. Momentum plays a role in the following Buy-Hold-Sell table.

The table below identifies the current holdings, percentages invested in each ETF, and the optimized percentages based on constraints that are not included in this article.

The Optimal Shares and Difference columns identify changes in the portfolio that need to take place to move the portfolio up and to the right on the Efficient Frontier graph. Buy and Sell recommendations take into account the optimum shares to hold, ETF ranking, and the ETF momentum factor. This table is designed to take much of the guess work out of that most difficult portfolio construction decision, what percentage should one allocate to each asset class.

Disclosure: I am long VTI, VTV, GTU, VOE, IWN, PCY, DBC, VWO, VNQ, RWX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.