As I have mentioned in several articles, there is a rebalancing premium whereby rebalancing back to target allocation allows one to "sell high" and "buy low" by selling asset classes that have performed strongly enough to grow above the target allocation and vice versa.
There are several methodologies for doing this ranging from the simpler to the more complex:
- Rebalance annually.
- Rebalance quarterly.
- Rebalance whenever an asset class has moved a designated percentage away from the target allocation.
With client portfolios I do a mix of 2 and 3. Currently there is a good rationale for selling some small cap value ETFs (VBR, PRFZ, IWD) and purchasing emerging markets ETFs (VWO, EEM and GMF emerging Asia). In fact, several opportunities have existed to do this a bit earlier in the quarter but it still looks attractive. I wrote on March 1 that managers were moving out of emerging markets offering a buying opportunity for long term investors. Such an opportunity existed immediately after the Japan earthquake. And the admission (not unexpected by me) that the nuclear danger is greater than initially anticipated created a bit of a selloff in Asian stocks on April 12. The commodity selloff affected related ETFs -- emerging Asia (GMF) dropped 1.3% Tuesday, Brazil (EWZ) -2.3% and the overall emerging markets (VWO) -1.8%. They recovered around half of those losses as of the middle of the trading day on April 13.
There were inflows back into emerging markets at the end of the quarter, nonetheless the disparity between small value (VBR, PRFZ, IWD) and emerging (VWO, EEM) is striking as seen below. Although the optimal time for rebalancing occurred, the move still makes sense.
While the principal reason for doing the rebalancing is the discipline based on the price movements, there are some economic rationales as well:
Valuation: As seen by the chart below (from the FT), emerging markets are valued below the long term trend. Although there is a large argument over the U.S. overall market valuation as discussed in a weekend WSJ article, the valuation of small value is quite high relative to historical levels on both a historical basis and its relationship to the overall market. The iShares website lists the trailing P/E for 23.89 and p/b at 1.82 that is actually higher than the S&P 500 at P/E at 19.44. So if one buys Robert Shiller’s side of the debate over valuation of the U.S. market S&P 500, it would certainly hold for small value, EEM emerging is listed at a P/E of 18.5.
Economic Growth: I am still a long term believer in emerging markets based on the arguments I made on the basis of long term growth. Additionally, consumers in the emerging markets are net savers and not strapped by holding real estate as their major assets, one which I view as having dismal long term (de) precaution prospects. As they channel that savings into domestic capital markets, it will be an additional demand factor. Indicative of this trend is the fact that emerging markets have gone from only 1% of world equity market capitalization a decade ago to a current level of around 12%. Doubtless, this is a trend that will increase and likely accelerate. That alone is an argument for a high weighting of emerging markets.
Currency Appreciation Several of these countries, most notably Brazil, with short term rates at 12.2% and India (INP) (7.4%), are already in a tightening mode in an effort to forestall domestic inflation. The high interest rates drive "carry trade" hot money into the domestic markets as they borrow lower interest rate currencies and invest in higher rate currencies (There is a carry trade ETF using mostly developed market currencies: DBV). The scenario for this trade is particularly attractive at this point with the prospects for low interest rates in Japan (currently .1%) and a weak yen in response to the rebuilding needs. This has given a lift to both the currencies and domestic financial assets -- a double positive for dollar based investors. Other emerging markets with relatively high short term rates are Argentina (12.4%), Indonesia (EIDO) (7.1%), South Korea (EWY) (3.1 %) and Thailand (THD) (2.45%)
My general approach has been a larger than market cap weighting in emerging markets. A cap weighted index, in my view, misses the fact that a far smaller part of the domestic economy is publicly listed relative to developed markets. This is reflected in the fact that a capitalization weighted allocation to emerging markets would be in the area of 12%, despite the fact that these countries are 50% of world GDP. I also benefit from the ability of my clients to access the DFA funds; the DFA emerging markets core fund (DFCEX) has a tilt towards more small and value stocks than the market cap weighted ETFs.
Rebalancing works. A portfolio allocated 50% to emerging markets and 50% to the U.S. total stock market rebalanced quarterly would have outperformed a non-rebalanced portfolio: 9.83% to 8.77% in annualized returns over the last 10 years -- that would be the difference of $100 growing to $157.37 vs. $133.32. Interestingly, the standard deviation for the two portfolios is identical, so at least for this period there was a "free lunch" from rebalancing greater returns with no more risk.
The growth of $1 over the last 20 years is here: