The Importance of Asset Allocation and Portfolio Rebalancing

 |  Includes: AGG, DIA, QQQ, SPY
by: James Picerno

There are countless investment strategies, but arguably there's only one true benchmark: the market portfolio, defined as a passive allocation to all the major asset classes, initially weighted by the relative dollar values and thereafter left to the whim of market fluctuation.

This benchmark isn't necessarily appropriate for everyone as an investment strategy, although it's easy and inexpensive to build, thanks to the proliferation of index funds, ETFs and ETNs. Yes, it's a mindless measure of the risk and return profile from a broad-minded definition of markets. And yet the results over time, although middling (as you'd expect), look pretty good these days.

Our definition of the market portfolio is a passive allocation to a global mix of equities, bonds, REITs and commodities. Our proprietary Global Market Index (GMI) fits the bill, though it is no silver bullet and has been known to lose money at times. But it offers a reasonable proxy for owning everything and questioning nothing. How has this know-nothing strategy fared? For the 10 years through the end of January 2010, GMI's posted an annualized 3.9% total return. That compares with a small annualized loss for the S&P 500 (-0.8%). Meantime, U.S. bonds overall have done better over the past 10 years via the Barclays U.S. Aggregate Bond Index (NYSEARCA:AGG), which is up 6.5% on an annualized basis.

There are alternative ways of profiling the markets, but this is a good place to start to tackle the burning issue in portfolio strategy: Deciding if it's timely to overweight this or that asset class and to what degree.

Then again, not every strategic-minded portfolio decision requires deep analysis. Some techniques for adding value are simple and require no particular talent or knowledge per se. That inspires looking to GMI and asking what can we do to enhance risk-adjusted performance with little or no effort? One answer is rebalancing, which we're defining as reacting to previous market changes. Tactical asset allocation, by contrast, is rebalancing based on forecasting. That's another issue entirely.

As for monitoring and measuring rebalancing's payoff, if any, we recently launched a companion index to GMI that is identical to the original except that it's rebalanced every December 31 back to GMI's initial asset allocation as of December 31, 1997, when the index was launched. How have the two benchmarks fared? The graph below compares results from the close of 1997 through the end of last month—a bit more than 12 years of history. (Click to enlarge)

As you can see, the rebalanced version of the index (GMI-R) has outperformed its unmanaged counterpart (GMI). On an annualized basis, that works out to around a 90-basis-point bonus for rebalancing. That's not surprising. A number of researchers, including author and financial planner William Bernstein, have found that rebalancing can add 50 to 100 basis points of incremental return for a diversified portfolio.

Of course, it'd be foolish to expect a rebalancing bonus to arrive each and every month like clockwork. Nor should we automatically assume that we'll earn more from rebalancing over longer periods, even a few years. Ideally, the rebalancing bonus will reveal itself over a full business cycle or two. But there are no guarantees. This is finance, after all. But as techniques for adding value go, rebalancing is among the relatively worthy choices to consider, either alone or in concert with other applications.

On that note, it's possible to earn a richer rebalancing bonus if we do something more than simply rebalance mindlessly at the end of every year, as is GMI-R's methodology. As I outline in my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, there are a number of techniques to consider for enhancing a naïve rebalancing strategy. For example, one could adopt of more opportunistic approach to rebalancing by focusing on those times when asset allocation changes to your portfolio are extreme. Watching performance momentum, relative return spreads, dividend yields (along with dozens of other metrics) have been shown to be useful at times as well.

Nonetheless, we can't lose sight of the fact that over the long haul, higher return generally arrives only by embracing additional risk. In the end, we're all risk managers. Then again, not all risk-management techniques are created equal. Rebalancing, for instance, is a technique that almost everyone can employ productively. Assuming, of course, you have a broadly diversified portfolio across the major asset classes.

Asset allocation and rebalancing, in sum, constitute the first two steps on the thousand-mile journey of investing.