Wealth in the Balance

The past decade sent all the wrong messages about

There's nothing like a bull market to cast portfolio rebalancing in a bad light. Rebalancing, of course, is the periodic buying and selling of investments within a portfolio for the purpose of restoring its original allocation. Since uncorrelated asset classes perform differently as economic conditions change, portfolios naturally drift from their initial weightings. In the unprecedented equity market run-up of the last decade, the winners just kept on winning. The idea of taking profits from stocks to increase one's positions in the fixed-income or real estate markets seemed like taking from the rich to give to the poor. Hopping from the fast track to the slow lane produced no apparent benefits; in fact, it decreased returns. And who wants to do that?

Now that the days of easy money for growth investors have faded, however, portfolio rebalancing doesn't look like such a bad idea after all. Let's take a closer at this important investment management process.

That Was Then

There's no question that non-rebalanced portfolios have outperformed in the last ten years. It's easy to see why: As equities have steadily risen throughout the bull market, a portfolio with an ever-increasing allocation to stocks could not help but outpace a portfolio rebalanced on a regular basis.

For example, suppose that a diligent investment advisor set an initial allocation of 60% stocks and 40% bonds for a client in 1995. By the end of 2000, the steadily increasing valuation of equities would have shifted the client's original allocation to nearly 80% stocks.

Because the non-rebalanced portfolio had a larger exposure to equities, the total return for the portfolio for the six-year period would be higher than for the portfolio that was rebalanced annually. But the amount of excess return--about 60 basis points (or 0.60%) per year--would come at a big price: The unbalanced portfolio experienced more than 20% more volatility. The bottom line: the Sharpe ratio of the rebalanced portfolio (which measures the risk-adjusted return of an investment) is more than 15% higher than for the non-rebalanced portfolio (see graph, page 90).

Even in the most extreme market cycle--in this instance, the highest five-year return for stocks ever recorded--a rebalanced portfolio garners a much higher risk-adjusted return than its non-rebalanced brethren. If that is the case during extreme examples, more normal market conditions must favor rebalancing even more.

"With the increased volatility of the markets during the last 12 months, we have certainly paid more attention to rebalancing," says Bill Johnson, consulting director of CapTrust Financial Advisors in West Palm Beach, Florida. "Instead of quarterly or semiannual reviews, we are monitoring client allocations on an almost continual basis."

Rebalancing also becomes more important if aggressive mutual fund managers are a part of the investment mix. "It is not unusual for a momentum-type fund to gain or lose 20% in one month. In that instance, it does not take long for portfolio realignment to become a necessity," says Johnson.

The Rebalancing Bonus

How can rebalancing be so beneficial to the investment process? According to Ronald Kahn, a managing director of Barclays Global Investors in San Francisco, the technique captures the tendency of capital markets to revert to the mean over long periods of time. "Rebalancing involves selling what has outperformed, and buying more of things that have lagged," says Kahn. "Markets have a tendency to outperform after a few years in the cellar, and this extra gain is captured through periodic rebalancing."

This "buy low, sell high" effect is often referred to as the rebalancing bonus. The size of this bonus is dependent on a number of factors. In general, portfolios with highly volatile but uncorrelated assets have the most to gain from regular rebalancing. According to William Bernstein, an investment advisor and publisher of the online journal Efficient Frontier (www.efficientfrontier.com), an annually rebalanced mix consisting of emerging market equity indices produces an excess return of 5.7% per annum compared to a passive, non-rebalanced portfolio. Even after adjusting for transaction costs and taxes, rebalancing still pays off big. As a result, Bernstein recommends buying emerging market funds that rebalance their country exposures regularly, as opposed to capitalization-weighted international index funds.

Another area where rebalancing seems to pay off is U.S. small-capitalization stocks. The low correlation of these stocks and their high volatility make them perfect candidates for generating a rebalancing premium. This extra return largely explains the enhanced value of active management versus an indexed strategy in the small-cap universe, which is one of the few areas where indexed investments have lagged over long periods of time (see sidebar on right).

But not all are convinced that rebalancing can create the same degree of real-world gains that it seems to generate on paper. "Rebalancing is not a new concept," says Rob Reiner, managing director of international equities at Deutsche Asset Management. "Rebalancing can reduce risk by avoiding portfolio concentration in a few big positions. But that does not necessarily mean that there is a strong tendency for mean reversion in the capital markets. The markets are too efficient to exhibit that type of simple price movement."

In Reiner's view, advisors who rely on rebalancing are too focused on performance relative to indexed benchmarks. "Alternatively, international managers that are intent on delivering good absolute performance will concentrate on other ways to generate return, such as stock selection and the prudent management of currency risk."

Even so, Reiner admits that it is hard to completely ignore the concept. "We tend to trim down positions that have grown due to appreciation, and add to stocks that have suffered." Vijay Chopra, the director of research, echoes Reiner's viewpoint. "Our ability to reduce positions in stocks as the share price goes higher is really a byproduct of our sell discipline, which puts target prices on all positions."

This view nearly puts rebalancing on par with active management. But just because cap-weighted indices are not rebalanced does not mean that rebalancing is not a good complement to passive management also.

In the Zone

Rebalancing has even received a fair bit of attention from academia. Most of the research on the subject recommends using "no-trade zones" around a client's asset allocation targets, and only rebalancing when those targets are exceeded.

A recent paper by Hayne Leland of the Haas School of Business at the University of California at Berkeley (http://econ-wpa.wustl.edu/eprints/fin/papers/9610/9610004.abs) is a case in point. Leland suggests that, for a 1.5:1 stock-bond ratio (i.e., a 60% stock /40% fixed-income asset weighting), no readjustment should be made when the stock-bond ratio remains between 1.44 and 1.56. If the ratio moves above this range--say, to 1.58--then trading should take place to restore the ratio only to the upper band (1.56). In this approach, transaction costs and "tracking error" (the difference between the actual return and the return of a perfectly weighted portfolio) are minimized.

Barclay's Kahn is a big fan of no-trade zones. "Most of the time, the portfolio naturally drifts back in the direction of the target allocation," he says. "Using these zones can significantly reduce both transaction costs and realized capital gains."

Johnson also favors no-trade zones, but for a different reason. "There are occasions when a fund manager is shooting the lights out, and if it is due to an intermediate or long term economic change, the last thing you want to do is take money away from him. No-trade zones give these investments room to run," he says.

There is a more practical reason why a gradual approach makes sense. As clients get older and their retirement savings grow, their objectives naturally change over time. Acknowledging that individual portfolios should slowly migrate toward a more conservative posture is an important element in a long-term rebalancing program.

The Price Tag

Like any investment decision, rebalancing isn't a free lunch. While smart rebalancing can enhance returns while reducing risk, an ill-conceived rebalancing plan can cost a great deal.

Rebalancing and Index Funds

Since the vast majority of passive investment products are based on capitalization-weighted indices, these funds are never rebalanced. As a result, they tend to be increasingly dependent on a few relatively large-cap stocks for performance. The S&P 500 index is a case in point; after five years of big gains, about one-half of the index's value is concentrated in the largest fifty stocks.

Pricier alternatives to index funds are structured offerings that rebalance their portfolios in an effort to minimize this concentration effect. DFA Emerging Markets Fund (DFEMX), for example, equally weights to 11 countries contained in the Morgan Stanley Europe, Asia, and Far East Index (EAFE).

Is the DFA fund worth the extra 1% fee over passively managed funds like the Vanguard Emerging Markets Index Fund? It has been in the past. Since 1995, the DFA fund has beaten the EAFE emerging markets index by about 3% per annum after fees.

But don't expect the same type of superior return with a rebalanced large-cap fund. Since such stocks have relatively low volatility and the correlation within the large-cap universe tends to be high, rebalancing costs outweigh the benefits. Investors are usually better off with exchange-traded funds or low-cost open-end funds like the Vanguard 500 Index Trust (VFINX).

The best bet for constructing a portfolio that can benefit from rebalancing is to include asset classes that benefit from a variety of economic conditions. Diversifying among the growth/value and large-cap/small-cap categories makes sense, as does adding non-correlated investments such as managed futures and high-yield debt to the mix.

Critics of rebalancing cite increased capital gains and the transaction costs incurred by shifting assets around as drawbacks to the process. Others tend to avoid rebalancing because of a distaste for pulling back on winners in order to finance laggards. For these reasons, many planners tend to revisit allocations only when things get severely out of whack. But by not doing so, these advisors miss out on the golden opportunity to sit down with their clients on a regular basis to review what has worked and what hasn't.

A large part of rebalancing is just good common sense. Mark Dillon, a financial planner and investment advisor with Park Meridian Bank in Charlotte, North Carolina, lets tax law dictate a large part of the rebalancing process. "Although I have quarterly meetings with all clients, we usually rebalance once a year. Most of this process is dictated by taking capital losses to offset gains. Last year is a case in point. We were very busy realizing losses to offset capital gains, as the market sell-off forced many mutual fund managers to take gains on their positions.

"We have also found that it is much better not to reinvest capital gains or dividends on mutual funds. By doing this, there is ample cash at year-end to pay capital gains taxes, and any remaining cash can be used for rebalancing. And by not reinvesting, it's much easier to keep up with the cost basis on mutual fund shares."

Indeed, wrapping the concept of rebalancing around tax-loss selling goes a long way in minimizing the impact of realizing gains and incurring additional transaction costs. In planning for tax-loss selling, there are a few rules to keep in mind. Probably the most important caveat is that there is a difference between short-term losses (i.e., those generated in less than 12 months) and long-term losses (those associated with a one year or greater holding period. The IRS requires that short-term gains must first be used to offset long-term profits, and only to the extent that they exceed the long-term gains can they be used to offset short-term gains.

A Step Further: Reallocating

Some investment advisors do not stick with fixed allocations. Citing the need to respond to changing economic conditions, they do not merely rebalance--they reallocate their client portfolios in response to changing macroeconomic conditions.

"In many cases, calendar-based rebalancing does not give you much bang for your buck," says Louis Llanes, president of Blythe Lane AssetManagement, a Denver-based money management firm. "Take Japan, for example. If a planner took money out of winning positions and increased his allocation to Japan, over the last several years he would have done nothing but throw good money after bad."

Instead of periodic rebalancing, Llanes is fond of tactical asset reallocation. "We change our investment weightings for a variety of reasons. Sometimes it is prompted by volatility increases in certain markets. Other times, it's due to changes in monetary policies, either domestically or abroad."

Kahn takes a similar view, but only when economic conditions change. "Advisors need to ask themselves if they have new information that justifies a strategic shift in investment policy. If not, it is probably better to leave things the way they are."

Such a take on asset allocation seems to fly in the face of market efficiency. But according to CapTrust's Johnson, the very fact that markets are not predictable gives credence to reallocating. "Take a fund manager who, after years of 20% returns, suddenly gains 50%. I would argue that because of efficient markets, this type of outperformance is not sustainable. From that standpoint, it certainly makes sense to reallocate some of the manager's profits to other investments."

Johnson says that his strategy worked like a charm last year. "We consistently took profits from our growth and momentum managers through the big run-up in the summer. By the fourth quarter, we were down to a minimal allocation to tech, and had large positions with value funds. This made a huge positive impact on our client returns."

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