Asset Allocation And Rebalancing Review

by: James Picerno

The federal government's partial shutdown is no closer to resolution, but so far the markets are shrugging off Washington's fiscal stalemate. It remains to be seen if the indifference will endure if the deadlock in Congress continues and the threat of a self-inflicted default draws closer. "On [October] 17th, we run out of our ability to borrow, and Congress is playing with fire," says Treasury Secretary Jacob Lew. "If they don't extend the debt limit, we have a very, very short window of time before those scenarios start to be played out."

If all this poses a risk, and it does, Mr. Market is showing minimal signs of distress at the moment. Notably, US stocks are still trading near their highs for the year. Our proxy ETF for domestic equities (Vanguard Total Stock Market (NYSEARCA:VTI)) is up a hefty 22% year to date through October 4. The big loser among the major asset classes is a broad basket of commodities, based on the iPath DJ-UBS Commodity Index (NYSEARCA:DJP), which is lower this year by almost 10% as of Friday's close.

For another perspective, consider the relative changes in the asset allocation of an equal-weighted portfolio of the major asset classes this year. The chart below depicts the current portfolio composition (based on proxy ETFs) in context with the range of allocations year to date, based on a start date of Dec. 31, 2012 for the equal weights. The strategy for this illustration is equally weighting everything and letting the unmanaged allocations fluctuate freely through October 4.

Turning to a review of how the individual markets have performed, the next chart shows the year-to-date results in relative terms through October 4 with all the ETF prices rebased to 100 as of Dec. 31, 2012:

Next, here's how an ETF-based version of a passive, market-value-weighted mix of all the major asset classes stacks up so far in 2013-the Global Market Index Fund, or GMI.F. This investable strategy benchmark is higher by 8.9%, or roughly midway between the year-to-date returns for US stocks and bonds.

In addition, consider how the Rebalancing Opportunity Index (ROI) for GMI.F has evolved. This benchmark, which uses the dispersion of returns as a measure of the fluctuating potential for enhancing return, lowering risk, or both via rebalancing, is currently close to neutral in its near-zero reading. In other words, the potential for adding value with rebalancing looks relatively low compared with the 150-plus levels in May 2013. (Note: ROI's calculation in the chart below is based on rolling 1-year returns for each of the 14 ETF components in GMI.F--the "standard" view on these pages. Adjusting the historical window to reflect alternative time horizons and/or the asset mix will dispense different ROI values. For a brief overview of ROI, see this post.)