Recent Rebalancing Subsequent Quarter Results

Sep 29, 2011

As we head to the end of the quarter, the idea of re-balancing is back making the rounds in the media and by fund companies.

When treasury bonds outperform the S&P 500, you will often get a rebalancing by large institutions. We saw this at the end of June 2011. Let’s take one type of look at how this rebalancing trade has worked in the subsequent period (quarter).

We used the 5-year treasury bond index and S&P 500 since 2000. 5-Year Bonds have outperformed stocks by at least 3 percentage points in 16 calendar quarters since 2000. In the next quarter, the S&P 500 tended to be very volatile, dropping 9 times with an average -10.6% loss. The other 7 times it rallied on average +11.0%. So in case you weren’t already thinking so --- don’t be surprised to see a big move in Q4 one way or the other.

At the end of June 2011, the story was that funds rebalanced towards stocks. We have always questioned this type of conventional wisdom and wrote instead about the opposite --- that there was relative strength in bonds. As it turns out re-balancing to stocks in June was a poor decision --- stocks suffered significant double-digit losses in Q3 2011 and treasuries continued up. Indeed, the spread between being long ~5 year Treasuries and long S&P 500 is 17.7% since June (with a few days in the quarter left).

Large funds would argue that the trade is not an attempt to be a money-making move --- just a long-term adjustment back to neutral. That is fine -- but others seem to take it and imply its a useful strategy. As we noted previously ( Rebalancing Theory & Nuances ), the value of re-balancing is not a significant source of value-add. The ‘allocate and re-balance’ conventional wisdom is in our view materially overrated by the buy-side community. The results (below) are quite wild so there isn’t a lot to be drawn bearishly either – it’s just more a matter of the fact that this does not have the characteristics of what constitutes good supporting evidence of a strong strategy (lowering risk and/or materially better return relative to that increased risk).


Here is sample of recent results:


New Product, Check It Out:

New Allocations Module Blog


Low Interest Rates Hurt? Reality Check

Sep 24, 2011 in Bonds

One thing we hear is that today’s low rates are bad for savers that own bonds.    What?    Last time I checked, a nice return is good for a saver.



Bonds do not return just their stated yield-to-maturity (unless it’s both a zero coupon bond and held to maturity). As any credible fiduciary is well aware, there has been significant appreciation in the prices of various bonds recently.    Any bond-market investor is sitting on a strong return right now.

Complaining about low yields is a bit odd.    It is a lesser version of having owned Apple all the way up and then complaining that the market cap is so high it leaves little room for more upside. Reality check -- already made an outsize profit.   Low yields now mean that bond investors just made a lot of money on the capital appreciation side. People barking at Bernanke for keeping rates low and not allowing savers to make money is almost comedic --- the YTD total return of IEF is +14.7%.    Maybe savers should celebrate by getting their duration down and be happy with making 2 years of 7% return in just the last 6 months.  Perhaps they should consider gradually moving towards lower credit-quality bonds --  where rates have gone UP recently, not down.    Markets are dynamic, smart rotation is necessary to achieve a good return.

It seems to us that a stunning amount of investors just don’t understand the bond market. It is not a monolithic market that can be summarized with mentioning the current 10-year treasury yield.   Bonds with very long maturities are risky --- they are often more risky than a typical stock index.   Look at EDV or ZROZ or TLT--- these funds are extremely volatile. Just because they are labeled bonds absolutely does not make them conservative investments.Conv ersely, ultra short-term bonds have no sensitivity to interest rates -- they mature so fast that higher rates means higher re-investment rates for these maturing bonds --- these funds have obviously not appreciated much this year.

We like focusing mostly on the intermediate duration segments.   You get all the non-correlation benefit when things like equities are not attractive (like recently)--- you also get a decent lower-risk return while you wait for this equity market downtrend to run its course. And perhaps most importantly, short and intermediate bonds won’t get the large drawdowns when TLT and other long-duration bonds eventually tank (yields rise).

See also:

Yield To Maturity Charts Don't Tell The Full Story


New Module: Allocations [Beta]

Sep 19, 2011

We have added a new module to that expands the functionality in a logical way. It is located on the My Account tab: has advanced methods for screening and backtesting various relative strength and moving average strategies. The community runs thousands of backtests and it makes sense to see how members may be able to help each other with shared research ideas.

If you think about portfolio management, it doesn't matter what your process is --- in the end, when each day closes --- you have a portfolio filled with securities. Even if your portfolio is mostly cash, that is still an allocation. So our new Allocations module allows you to go to the final step in a process -- that is, take everything you know --- from fundamental to quantitative etc... and create an allocation. Once set-up, we will automate the tracking of the total return -- as well as calculate some of the most important items --- such as your portfolio volatility and portfolio drawdowns and sharpe ratio etc...

Importantly, you can do this privately if you would like --- or you can place the allocation you create on the public Allocations Board. You create your own customized fund symbol (ie, ETFRS) to identify the allocation. You can comment on each others allocations or choose to have comments turned off. You can keep watch lists of various strategies (from those which have chosen to be public). You can delete or create new allocations. We have tried to design it in a way that simply helps you to make better portfolio decisions. And as we've done with all of our applications, we will make the module significantly better over time. has provided research applications that aid in the investent process --- but we simply can't model every possible variation of your requests into a few clicks. After you have researched and tested some ideas and have weighed all the variables and then have decided what to do, what we can do is capture the final allocation that you enter.

Note that we have installed some rules that may seem a bit rigid at first --- but these rules are necessary as we do not want to have this become a short-term trading competition. This is about portfolio management, not the latest earnings speculation or the macro news-of-the-day. The graphic below is one way to visualize the process as we see it.



Note that you can set an allocation to begin and it will use that days closing values. You can update on any day and it will then save the result of the historical fund return and subsequently combine that with the return of the new allocation. We will capture the total return of all securities (adjusting for dividends & cap gains distributions) so that your income securities are properly tracked. We know that relative to a real account, sometimes you will get a price that is different than the closing price -- but this is an allocation app and its purpose is to show various types of portfolio strategies --- not to perfectly mimic intraday trades.

Over the long-run, allocation moves are the overwhelmingly dominant factor in portfolio performance. Sometimes you may get into an ETF at a price $0.25 better than the closing price --- but this will be partially offset by the times your entry is worse. In the long-run, this is a lot less important than other factors.

We have been in beta testing on this the past few months and have worked out many of the details. We plan to add various features to this module over time. We are calling this a BETA product for now as we may have some plumbing adjustments necessary depending on how many people find use in this module and will surely have to allow for the scaling of data should many people like this feature. So please give it a try and tell us how you like it -- it is included in your existing subscription so there is no additional cost. We are excited about the potential this new application has should the community begin to share ideas and learn from each other not just through talk --- but through portfolio allocation actions.



High Correlations? And what?

Sep 15, 2011 in Correlation

This is getting silly.  Portfolio managers around the world are complaining about high correlations.   The truth is that things that are somewhat correlated to start with (stocks) will see their correlations go higher when volatility rises -- it's not a mystery, its mathematical.   This has happened many times and while people are now saying ‘all-time high correlations’ – this misses the much more important point.

Crises cause securities to have larger than normal moves --- and correlation is a measure of how far one security moves in relation to the movement in another. Essentially, when one security has a big move vs its history, does the other also have a large move relative to its historical movement?   

Correlation is somewhat of a tricky topic.   Something may move very little but still be highly correlated to something that drops a lot.   Look at the utility sector (XLU) vs the S&P 500 (SPY).   XLU has a 0.89 correlation to SPY over the past 60 days.   But XLU is slightly positive so far in Q3 while SPY is currently -9.5% QTD.

Let's do a portfolio example just to see how better to think about this.  If I take 85% ultra-short term bonds (t-bills), but blend it with 15% KBE (bank industry etf) and I compare this to 100% bank index, the result is like this:


You can see how the cash has diluted the loss to just -3% this quarter.   (KBE is -21.1% during the same period).   The correlation has been 0.99 - 1.00.   From this standpoint, a correlation of 1.00 has told you nothing about the true risk in this case.   The correlation is so high obviously because the combination of KBE and t-bills moves a lot whenever KBE moves a lot.  It doesn’t move a lot on an absolute basis --- but it does move a lot relative to its historical range of movement.    Easy enough.


So back to using different securities --  utilities high correlation with the S&P 500 hasn't prevented it from going up recently (slightly).   Utilities have gone up despite the correlation between these two rising.  Thus, when portfolio managers are complaining about high correlations – they are just really complaining of the natural result of high volatility.

Earlier this year we created a simple – but what we think is more useful --- application than your standard correlation matrix.   The ‘Down Day Stats’ module measures how much various ETFs move on just the days a benchmark drops more than X%.


Let’s use the industry ETFs (equities only).  We can use SPY to show all down days this year.   You find that defensives like Pharmaceuticals, Food & Beverage and Telecom outperform on down days.   Energy and mining do the worst.


But then flip it around, use the inverse S&P 500 (SH) to show what happens on up days.   Energy and mining are best and defensives are worst.   They are all highly correlated – so you must consider volatility #1 --- and then think about correlation #2.   It would be nice if lots of equity securities were not correlated.  But the fact is they are and it gets worse whenever there is a crisis. If you want a market that is less correlated, then you need to have an extended period without any volatility storms.


Summary:  If the market goes down, volatility will rise and this will push correlations up.  If the market goes up, the reverse will occur.   How many times have we seen this over the past 15 years? Many.


Why would it stop in 2011?


See also 2010 Posts On Correlation



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