How Rebalancing Added Over 2% to the Returns of a Simple ETF Portfolio

Rebalancing is a key to lower risk and higher returns because it forces the discipline and takes the emotionalism out of “buy low and sell high.” The illustration below shows how a simple portfolio that has a target allocation of 50% bonds and 50% stocks gets rebalanced as the allocations move away from their targets.

Our ETF portfolios run by our company, MarketRiders, have weighted average fees of .17%. The service does what a wealth manager’s expensive rebalancing software does – except our customers save on the onerous fees. This posting explains how in the last 12 months, rebalancing added 2% - 3% returns to a variety of portfolios with varying bond / equity allocations.

Finance geeks love to debate the pros and cons of rebalancing and in particular, how often one should rebalance – monthly, yearly, quarterly – based upon a fixed time interval. Or they discuss whether it even makes sense to rebalance, using studies that were performed over a time interval.

But most of these debates are borderline ridiculous because as the word would imply -- rebalancing should be done when a portfolio is out of balance. Rebalancing should have nothing to do with a calendar event, and everything to do with when a certain target allocation moves beyond a certain threshold. We call this “event-based” rebalancing, not “time-based.”

For example, today, many should “trim” not sell, some of their equity ETFs, which have gained so much over the last 6 months, and add to their bond ETFs. Trim the winners. Add to the losers. And do it now because they are out of balance, not because of today's date.

Whenever you add or withdraw funds from a portfolio, you should buy ETFs in a way that brings a portfolio back to its target allocations, i.e. use the opportunity of this event to rebalance.

A rebalancing event can be triggered in various ways, with various levels of sensitivity. For example, do you rebalance when an asset class, an ETF, or the entire portfolio is out of balance? We have sophisticated internal software tools used to “tune” our algorithm as to how sensitive it is to events. For this posting, I’ve used this software to demonstrate the power of rebalancing.

Here’s an interesting illustration of how rebalancing works. Our “Balanced Focus – 50% Bond” portfolio is a globally diversified portfolio with 6 core asset classes: bonds, emerging market stocks, foreign developed stocks, inflation proof US bonds, real estate and US Stocks and includes the following 15 ETFs: BIL, BIV, BLV, BSV, LQD, VWO, EWC, VGK, VPL, TIP, RSR, RWX, IJH, IJR, and SPY. Below what a $100,000 portfolio looks like.

We just finished perhaps the most volatile year in the US stock market since the Great Depression. For the 12 months ending 9/30/09, this portfolio, without rebalancing gained 2.01% and with rebalancing, gained 4.04%. Returns doubled from rebalancing, without any greater risk.

In the graph below, the yellow diamonds show the 4 times rebalancing alerts were triggered: in 2008, October 9^th and November 14^th and in 2009, on February 17^th and May 4^th. The blue line is the portfolio that was rebalanced and the red line is the portfolio that is “unbalanced.”

Its also interesting to compare the ending asset allocations on the rebalanced versus the unbalanced portfolios. As you can see from the chart below, when the portfolio was not rebalanced, Bonds (including inflation-proof US bonds aka TIPs) grew to 53% of the portfolio, from a target allocation of 50%.

By rebalancing, the investor was advised to buy more equities as they were declining, and while painful (especially in March 2009), the investor was ultimately rewarded. This ending portfolio shows a Bond allocation of 45% -- getting close to a rebalancing event.

Here are the results when we ran the same simulations on a few of our other ETF portfolios:

Comments

[Analyste de Boston]

I think it's somewhat misleading to say 'over the last 12 months, our rebalancing added 2-3% to client returns.' First, we've had to extraordinary cycles Bear & Bull that necessitated rebalancing if that's in your mandate. You likely rebalanced sometime in the BEAR (10/9/07-3/9/09) costing your clients >2-3% return, and if you rebalanced AFTER June your client likewise 'lost' potential upside gains. So a 12 months snapshot (here) is as meaningless as an annual or quarterly rebal, and not demonstrably "better."

Cookie-cutter asset allocation models with auto-rebalancing in any time-frame all failed to protect investors and cost them a fortune! (I designed such lifestyle models for institutional clients, over $2 bln was invested in 2007.) The average long-term 2020 investor is still DOWN -14% from 10/9/07, where s/he was 12 months ago is less significant.

I've personally favored strategic models for private investors since 2005, but that's a more complicated, labor-intensive & expensive value-proposition to sell to institutions and retail investors.

My Long Term/Growth Portfolio is UP +76% since the Bear Mkt began through 10/12/09. "Diversified strategic allocation" is the way to go!

2009 Oct 14 02:20 PM

[Robert Martorana]

Analyste,
I agree with you that auto-rebalancing is not the solution for everyone. Most clients want strategic AND tactical asset allocation advice, and they want customized advice. The wealth management industry prefers simplistic risk buckets, however, because these are cheaper solutions, and because the compliance risks are lower.
______________________...

Mitch,
Your process makes sense for institutional investors, and for individuals with fixed asset allocations. In these cases, your methodology would work, assuming that stock and bond market volatility is rangebound, and does not trend sharply higher or lower, as it did during 2008.
Nevertheless, your process assumes that investors do not need tactical or strategic changes in asset allocation. If changes are not warranted due to client circumstances or the market outlook, then the process makes sense. But as I pointed out to Analyste (above), these are very big assumptions.

Your very low expense ratios would seem to make customization virtually impossible: It's difficult to spend time with clients at a fee of just 0.17%. Any comments on how you deal with customization and/or tactical moves would be welcome.
Thanks,
Rob

2009 Oct 14 04:00 PM

[James Fowlkes]

Good article but you need to make the images clickable. It is impossible to read with the writing so small.

2009 Oct 14 04:10 PM

[Uday Maitra]

All this headache of rebalancing every month for that 2% - wouldn't transaction costs eat that up?

2009 Oct 15 05:07 PM

[Fund Insider]

I reduce taxes and transaction costs doing this by sweeping
all dividends to cash/mmkt and take that plus new deposits
to buy whatever is down below target allocation.

With this method, you can not only reduce cap gains after sales,
but also perform some strategic changes in asset allocation targets.
So if you are very bearish on stocks, your next purchases are based on a new target. If you must sell, I still avoid taxes by doing most of my selling inside 401k and IRA accounts (move them back and forth between bonds and stocks as needed, but mostly just buy new assets in taxable accounts).

2009 Oct 16 12:53 PM