If you think about the last few years, we’ve had stocks move to all-time highs in 2007, a big bust in global stocks in 2008 and a big move back up in 2009-2011 --  and then a sharp correction here again in Q3 2011.   

Something like rebalancing a portfolio during these moves was positive for return overall using the simple assumption of using just stocks and bonds.   However, as with nearly everything in portfolio management –there are caveats and nuances that surround every commonly accepted 'rule.'   

For example, a 60-40 stock bond portfolio picked up good return by periodic re-balancing over past 7 years.   It can be debated which is the best re-balancing rule ---  but it should be pointed out that rebalancing, while moderately useful – is not  a large source of value-add.     ‘Allocate and rebalance’ seems to be the most commonly advocated strategy among firms who are just happy to earn fees off your money.    What is often not openly disclosed is that rebalancing during a bull market (like re-balancing in the second half of 2009 -- away from stocks -- was in advance of large move up in 2010-11) hurts returns and offsets a portion of the value picked up when rebalancing works.   

Now assume your allocation was 55% Stocks, 35% Bonds and 10% Precious Metals ---- you would actually be better off having never rebalanced.    That is, the bull market in precious metals was more than the net benefit picked up by rebalancing other parts of portfolio (due partly to the cost of rebalancing in 2009 offset by the benefit of rebalancing in 2008).     Maybe this is obvious – maybe it is not.  But the point to remember is that rebalancing is something that can help somewhat over long-run --- though its total effect is likely overrated by most given what you read by financial firms that fail to acknowledge that this isn't a robust, universal strategy.    The REAL value-add is in portfolio management is having exposure to market segment leaders (this year that means stocks and commodities in Q1 2011 and precious metals & bonds since then). note: We are of course assuming you are always still staying within your broader risk tolerance when we discuss pursuing market leaders.

Note that our basic Portfolio Allocation Backtest App has a drop-menu for rebalancing rules.   To add some fun to this example, we use Berkshire Hathaway (BRKB) as the equity 60% -- and Bill Gross’s Total Return Mutual Fund (PTTRX) as the fixed-income 40%.     We compare this to a 55% Stock Index (SPY), 35% Aggregate Bonds ( AGG) and 10% Gold (GLD).    The rebalancing helps the Buffet-Gross mix --- but hurts the Stock-Bond-Gold allocation over this particular time period.

Equity Indices have confirmed the loss in relative strength made a few months ago -- snapshots below:

Country Funds (note the different types of countries that were already in downtrends at or before last month-end:   Canada, Australia, China etc...)

Here are 25 Very Common Indices (of course, bonds and gold have been in bull markets):

First, a look back at this past week.   While the flash crash of 2010 was a memorable one, this past week saw many indices go down more than the week of the flash crash.

We have made the point over and over and over again in this blog (and indeed the underlying thesis of the entire website) of how tactical allocation is what really matters to portfolio performance.    Picking stocks in an environment like August 2011 or May 2010 or Q1 2009 or 2H 2008 is akin to arranging deck-chairs on the Titanic.  Material larger tactical adjustments are the key decisions.  ETFs make at least the implementation aspect far easier for the investor.   

Bonds have been in a bull market for 4-5 months now.   We’ve written about the relative strength bonds have been showing --- but the parabolic moves of bonds here are unsustainable and lowering durations  is a prudent move, relative strength or not.  

The other big point we want to highlight is that of focusing on your Sharpe Ratio (volatility-adjusted returns) rather than just a traditional index.   If you are going for good sharpe ratio – and you should – then you will quickly see that you are not going to be able to get a good sharpe ratio if your portfolios standard deviation is too high.  Return is of course the #1 factor --- but remember this:   the higher the vol, the higher the draw  (as in drawdown).   

When we released the backtesting applications in 2010, we fielded some questions about how to implement the concepts --- which we then enhanced the apps with solutions to address these.   At the same time, we repeatedly discussed how the real important part was the higher-level decisions.   Implementation techniques are of course important – and we strive to be as specific as we can by using well-defined rules for the applications – but in the end, this month again shows that implementing the concepts and even just getting it ‘generally right’ is plenty good enough.

After a few flattish consolidation months, it may start to seem frustrating --- but this is how markets are – lots of low returns and then some non-linear bursts of movement.    Now after the steep losses of the market recently, getting bond market (positive) returns should sit just fine.   Indeed, the updated performance of the sample portfolio is +12.3% vs -4.6% for the S&P 500 YTD.   That is using ‘first day’ picks specified a full day in advance.   Using actual picks the return spread is a bit higher.   Similarly, the other simple portfolio we used as an example (last November) – called ’01 Beta Strategies’ is currently +1,590 basis pts better than the S&P 500 (+11.3% vs -4.6%) using first day picks.  

We would like to emphasize though that your time and effort should not be to obsess over how to beat the models -- or even track them perfectly.   Models always have some assumptions in them that will keep them from being perfectly realistic.     In the end though, it should just be to get it 'generally right' as often as you can -- and good models can clearly help in that regard.  

Lastly, we would highlight that research is an ongoing process, continual enhancing of strategies is important --- small improvements add up over time.    ETFs are an empowering innovation -- there are always a few very interesting new products that come out each year.   This industry is still in the early innings of its development.

As June ended, the story was the end of QE2.  The conventional wisdom at the time was that there would be no incremental buyer of Treasuries as the Fed ended its purchases on June 30th.    The story of the day was that stocks were cheap relative to bonds.  By the end of the month, the story was about the debt ceiling vote by Congress.   This will come and go and we will be on to the next employment numbers and european debt and whatever else comes along.  However, having a valid investment process that assesses conditions and adapts to them will serve to keep us on the right side of any intermediate or extended trends that appear.

Put yourself in the role of someone who stands in front of an investment committee – or a consultant that must travel around and tell the strategy of the firm.    It is very hard to come out with an argument that can defend a large overweight in treasuries these days.   Indeed, trying to find the reasons to buy a low single-digit yield can get you laughed out of the room.

So what happened during July?  Intermediate treasuries (IEF) rallied +3.2% and outperformed the S&P by 520 basis points (S&P 500 was -2.0% for month).

We think this is where professional investment advisors tend to really excel: in finding credit securities that are reasonable return for relatively low risk.   Intermediate corporate bonds as measured by the plain vanilla Vanguard Intermediate bond fund  (VCIT is the ETF version of VFICX) rallied +2.3% in the month, the 7th best return in a calendar month since 12/31/02 ( 103 months).  Here is the range for this index over that time period lined up from low to high:

There were of course other interesting things happening --- the Swiss Franc ETF (FXF) and all longer-term  bonds had strong months.   There were some tradeable longs in the Australian dollar (FXA) and elsewhere across the ETF landscape.

We believe that altering allocations --- even when using plain-vanilla index funds (which by the way are ultra low-cost and highly liquid) -- is a more powerful strategy than trying to understand business fundamentals of a few companies better than others.    To the extent you can find unique products that beat indexes, all the better.   But it is the basic big picture allocation that is the important part.    Do you think a $50 billion pension fund manager can nimbly move assets around on a monthly basis?  No.     Do you think that sub-second high-frequency hedge-fund trading signals affect calendar-month returns?  No.

As we’ve highlighted before, you can now trade index baskets for no commission and a penny bid-ask spread.   We live in a time that has never been so investor-friendly.

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