Rebalancing: Theory & Nuances

Aug 23, 2011

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.




Comments (9) -

Aug 23, 2011 11:24 #

Can we users enter fund symbols as well, or is this something only you can do?

Paul Belgium

Aug 23, 2011 11:29 #

Hi Paul,

Use PTTRX for Pimco Total Return mutual fund.   We have a number of index mutual funds in our system and just a few active funds -- such as Pimcos.    ETFs cover far more indices than mutual funds do so you can vastly more coverage with ETFs actually.    The only issue is that the index funds that do exist in mutual fund form have far longer histories.  Here is a sample:

VBINX - Vanguard 60-40 Balanced
VBMFX - Vanguard Total Bond Mutual Fund
VEIEX - Vanguard Emerging Markets MF
VEXMX - Vanguard U.S. Small-Mid Extended Mkt MF
VFICX - Vanguard Intermed-Term Invmt Grade
VFITX - Vanguard Interm Treasury Bond MF
VGSIX - Vanguard MSCI REIT Mutual Fund
VGTSX - Vanguard Total Int'l Stock Index MF
VTSMX - Vanguard MSCI U.S. Total Market
VWEHX - Vanguard High-Yield Bond MF
VWESX - Vanguard Long-Term Invest Gr MF
PREMX - T Rowe Price Emerging Markets Bond MF

Chris United States

Aug 23, 2011 11:47 #

Forgot to add.  

Note that a number of the Vanguard mutual funds carry redemption fees if hold for less than a year -- yes, even investor-friendly Vanguard still does this on a number of its funds.     No ETFs have redemption fees.    

btw,  the Vanguard High-Yield Bond fund is not technically an index fund -- and Vanguard for some reason doesn't have a High-Yield bond ETF.    HYG (from iShares) and  JNK (from SPDR) are largest high-yield index ETFs.

Chris United States

Aug 23, 2011 16:57 #

Chris, how about maintaining somewhere on your site a full list of all the non-ETF stocks or funds you have available in your database? Then we users can play around with whichever ones we want. Thanks.

Jim United States

Aug 23, 2011 20:19 #

Questions: 1)  Is the rebalancing function in your portfolio backtester a recent addition? 2) Can it be applied to a saved subscriber's portfolio allocation of 10-16 ETF's? 3) What are the frequency choices for rebalancing?  

I discontinued my subscription a few months back (after discussing with you), because it did not appear that rebalancing was available (now may recondsider).  I feel rebalancing is a critcal part of investment strategy, both in reducing volatility and taking advantage of the natural rotational cycles of certain asset classes and sectors.   Certain fixed allocations MIGHT have done better over a certain time period, but that is only helpful if you know future outcomes in advance.   Thx, mike

cheesey1 United States

Aug 24, 2011 06:34 #

The rebalancing feature can handle any saved portfolio up to 25 ETFs at your selected (saved) weightings and of course uses total return.   The method is based on calendar dates using annual (on Dec 31st) or quarterly (last day of quarter) or monthly (last day of month).  

Chris United States

Aug 24, 2011 08:24 #

Chris, thanks for your replies. Looking foward to new features in fall and winter.

Paul Belgium

Aug 24, 2011 16:38 #

Thanks so much for adding the requested rebalancing feature.  Please consider adding "weekly" to the frequency options.   I appreciate the effort to improve  the site.  P.S. your comments re:  over-reliance on backtesting are well-taken.

cheesey1 United States

Aug 26, 2011 16:49 #

Chris, how about maintaining somewhere on your site a full list of all the non-ETF stocks or funds you have available in your database? Then we users can play around with whichever ones we want. Thanks.

Jim United States

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