Asset Allocation And Rebalancing Review

by: James Picerno

Divergence. That's a good description for the major asset classes so far this year. The spread between the best performers and the laggards is relatively wide on a year-to-date basis through April 26, offering a mix of opportunity and risk. Par for the course, perhaps, but the divergence is quite striking nonetheless.

Consider how the numbers stack up on an equal-weighted basis. Imagine that on December 31, 2012 we bought everything, weighted the portfolio equally, and let Mr. Market run. The resulting asset allocation as of last Friday:

US stocks and REITs are leading the horse race for the moment, closely followed by foreign equities in developed markets. Meanwhile, commodities, emerging-market stocks, and government bonds in developed markets are the weakest members of the major asset classes on a year-to-date basis so far in 2013, based on our list of proxy ETFs.

For another view, here's how the year-to-date total returns compare, sorted by performance in descending order:

Graphing the relative returns for the year so far offers a more striking comparison, as the chart below shows. In this case, each of the proxy ETFs listed above is indexed to an initial value of 100 at last year's close and left to wander at Mr. Market's discretion.

The wide array of results may appear dramatic, but it shouldn't be too surprising. Diversifying across asset classes, after all, is a strategy that seeks to exploit the expected set of varied return and volatility correlations. By that standard, the year so far offers a rich opportunity set. The relatively wide spectrum of results at the moment implies that rebalancing's abilities for juicing performance, reducing risk, or both are intact.

As usual, however, there is doubt about whether the past will repeat and so the divergence, for all its implied opportunity, isn't easily accepted at face value. Maybe it's different this time. The impressive historical results that accompany a simple rebalancing strategy for the major asset classes always looks suspect in real time. As a pair of analysts (John Kiskiras and Andrea Nardon) remind in a recent study--"Portfolio Rebalancing: A Stable Source of Alpha?"--the "essential condition" for success with rebalancing is mean reversion. Robust volatility and correlation help, of course, and sometimes by a lot, but these are mostly "amplifiers" for mean reversion.

It's never really clear if mean reversion will prevail for any two asset class pair, which is one of the reasons for holding a broad set of assets. In a world of limited ex ante insight, diversification is an obvious risk-management tool. But in an asset allocation context, rebalancing is no less critical. Asset allocation and rebalancing together are a powerful combination, much more so than if one is used in isolation with the other. There's always doubt about how, or even if, history will repeat, however. That's a valid concern, and it's probably one reason why investors generally have such a hard time exploiting this strategic pair in something close to optimal conditions. But that's also why the rebalancing bonus has proven to be so impressive and persistent on an historical basis: the crowd tends to leave quite a lot of the associated opportunity on the table. Why? Let's just say that it's hard to be a contrarian.

That brings us back to the current divergence in asset class performance so far this year, which again raises the perennial question: Is it different this time? No one really knows, of course. That's why there's a risk premium associated with asset allocation and rebalancing in the first place. Just as Rick mistakenly went to Casablance for the waters, if you thought rebalancing and asset allocation provide a free lunch, you too have been misinformed. Ah, but you'll always have Paris.