Stock and bond price co-movements appeared to decouple a few years ago, which exacerbated an already decades-old trend. Although the two asset classes don’t move in perfect lockstep–one falls while the other rises, and vice versa–it seems that correlations are much lower than they have been.

If one uses historical assumptions on correlation levels, efficient frontiers will restrict the amount of the riskier asset. The result is likely a lower realized return, which partly explains the shortfall of many defined benefit plans. One way to combat this problem is portfolio rebalancing, which involves taking money out of investments that have done well and putting it in investments that haven’t. This practice ensures that an investor’s asset allocation mix does not vary too much from its initial targeted amounts, which prevents concentration in a particular investment.

When one asset is on a tear, as during periods when stocks are dramatically outperforming bonds, for example, rebalancing will not increase the return of a portfolio. But during stagnant markets or periods when the correlation between assets is low (sound familiar?), rebalancing can add a ton of value.

During periods of low correlation, rebalancing a domestic portfolio can add up to 50 basis points per year in added returns with a reduction in risk. For those invested in higher volatility asset classes such as emerging markets, the so-called rebalancing bonus can be as high as 200 basis points. Rebalancing is a slam-dunk method of adding value, and if correlations keep heading lower, it’s a value proposition that will become increasingly attractive.

The Monthly Index Report for November 2005

Index

Oct-05

QTD

YTD

Description
S&P 500 Index*

-1.77%

-1.77%

-0.41%

Large-cap stocks
DJIA*

-1.22%

-1.22%

-3.18%

Large-cap stocks
Nasdaq Comp.*

-1.46%

-1.46%

-2.53%

Large-cap tech stocks
Russell 1000 Growth

-0.97%

-0.97%

1.23%

Large-cap growth stocks
Russell 1000 Value

-2.54%

-2.54%

3.03%

Large-cap value stocks
Russell 2000 Growth

-3.70%

-3.70%

-1.28%

Small-cap growth stocks
Russell 2000 Value

-2.51%

-2.51%

1.40%

Small-cap value stocks
EAFE

-2.91%

-2.91%

6.31%

Europe, Australasia & Far East Index
Lehman Aggregate

-0.79%

-0.79%

1.02%

U.S. Government Bonds
Lehman High Yield

-0.70%

-0.70%

1.33%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

-0.31%

-0.31%

1.20%

Managed Futures
3-month Treasury Bill

2.13%

All returns are estimates as of October 31, 2005. *Return numbers do not include dividends. ** Returns are estimates as of October 28, 2005