Time to Rebalance Your Portfolios

Portfolio rebalancing is perhaps the only 'free' lunch once you have set a strategic portfolio allocation based on your risk profile. Numerous articles have been published to study the pros and cons of portfolio rebalancing. The key factors behind portfolio rebalancing are:

• Risk and return control: when certain assets have appreciated too much, you would like to "take some money off the table" by selling portions of assets to bring back to your preset allocation targets. When certain assets have gone down too much, you would like to "buy cheap" so that you could take the "on sale" opportunity.
• Psychological feeling: when your portfolio allocation is out of balance, the over weight or under weight will give you uneasy feeling. Such a feeling is best described as the urge to do something in behavioral finance. Investors so often want to do something about their investment and most of time, they venture into markets without a clear guideline on their portfolio allocation. By the time they realize, their portfolio is out of whack and very often, they also lose money. Portfolio rebalancing with target allocations fixed is a sensible safe guideline to curb such "random" behavior.

As stock and other assets have appreciated so much recently (see the following table), the uneasy feeling on a looming correction is on everyone's mind. Now that we are approaching the end of third quarter,  it is time to have a checkup on your portfolios. 

Major Asset Performance

as of 9/25/2009, sorted by 13 weeks performance

Description	Symbol	1 Week	4 Weeks	13 Weeks	26 Weeks	52 Weeks
US Equity REITs	VNQ	-5.38%	3.39%	33.72%	71.82%	-29.51%
International REITs	RWX	-3.54%	3.64%	22.04%	58.26%	-11.72%
Emerging Market Stks	VWO	-1.94%	6.28%	18.57%	56.09%	10.61%
International Developed Stks	EFA	-2.43%	2.22%	18.04%	45.45%	-6.10%
Frontier Market Stks	FRN	-1.31%	5.61%	17.89%	60.39%	-5.25%
US Stocks	VTI	-2.40%	1.79%	15.16%	30.68%	-11.42%
US High Yield Bonds	JNK	0.84%	5.94%	13.83%	38.80%	10.95%
Emerging Mkt Bonds	PCY	0.04%	3.72%	13.43%	26.74%	22.77%
International Treasury Bonds	BWX	0.05%	2.95%	6.49%	13.47%	10.91%
Municipal Bonds	MUB	0.47%	2.58%	5.93%	7.20%	10.80%
US Credit Bonds	CFT	1.06%	1.62%	5.54%	15.49%	16.50%
Gold	GLD	-1.69%	3.33%	5.10%	6.96%	11.96%
Total US Bonds	BND	0.46%	0.81%	2.29%	4.33%	7.13%
Intermediate Treasuries	IEF	1.10%	0.93%	1.89%	-2.87%	6.96%
Mortgage Back Bonds	MBB	0.31%	0.62%	1.57%	2.06%	7.93%
Treasury Bills	SHV	-0.02%	-0.01%	-0.03%	0.07%	0.60%
Commodities	GSG	-2.24%	-5.34%	-2.92%	12.76%	-47.54%

The most popular rebalancing method is to periodically rebalance monthly, quarterly or annually rebalancing. For people who would like to be more active, opportunistic rebalancing strategy proposed by Gobind Daryanani from TD Ameritrade Institutional has shown to be effective if proper parameters are chosen. The opportunistic rebalancing method examines a portfolio periodically (such as biweekly). For those assets whose allocations are out of certain preset threshold (such as 20% more or less than the target percentage), these assets are rebalanced back to their target allocation percentages. For example, an asset with 30% target allocation would be rebalanced back to its 30% target if its allocation is over 36% or under 24%.  The following table compares the performances of three methods: no rebalancing, annual rebalancing, quarter rebalancing and opportunistic rebalancing (monthly check and 20% band) on a Roger Gibson Five Asset Portfolio.

Annualized  Return	Last 5 Years	Last 3 Years	Last 1 Year	Since 12/31/1997
Opportunistic Rebalancing Monthly 20% Band	3.39%	-3.35%	-15.67%	5.61%
Roger Gibson Annual Rebalancing	2.37%	-4.4%	-17.6%	5.41%
Roger Gibson Quarterly Rebalancing	3.09%	-3.7%	-16.15%	5.31%
Roger Gibson Monthly Rebalancing	2.35%	-4.65%	-17.84%	4.92%
Roger Gibson No Rebalancing	1.69%	-5.85%	-18.77%	4.17%

It should be noted that there are various parameters to be set for the opportunistic rebalancing method. Some of them are not as good as even a periodical rebalancing. However, rebalancing in some way definitely helps to improve your portfolio performance. Interested readers could further compare the risk (standard deviation and maximum drawdown) for these portfolios (and their various settings) from here.
It is also interesting to apply timing techniques to portfolio rebalancing.  In our previous article we showed that applying timing to a diversified portfolio could reduce risk and enhance return. Using this in a portfolio rebalancing manner deserves a separate serious study.

Buffett Stock Market Indicator: Simple Yet Effective

In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publically traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that  

"The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment".

He further went on to say

"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire".

Such a simple yet elegant metric (we call it Buffett Stock Market Indicator) could be implemented in several ways. At the moment, ValidFi maintains a strategy called Warren Buffett Total Stock Market Value to GNP Ratio Strategy. This strategy characterizes the stock market valuation into the following five categories: 

• Significantly Overvalued (SO): such as if the ratio >= 115%.
• Modestly Overvalued (MO): such as if   90% <=  ratio < 115%.
• Fairly Valued (FV): such as if 75% <= ratio < 90%.
• Modestly Undervalued (MU): such as if 50% <= ratio < 75%.
• Significantly Undervalued (SU): such as if ratio < 50%

These five categories are determined by four valuation parameters (such as 115%, 90%, 75% and 50% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what category the US stock market valuation is and then does the following rebalancing:

• SO: 0% in stock, 100% in cash.
• MO: 25% in stock, 75% in cash.
• FV: 50% in stock, 50% in cash.
• MU: 75% in stock, 25% in cash.
• SU: 100% in stock, 0% in cash.

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect such as only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

• SO: >=115%, MO: [90%, 115%), FV: [75%, 90%), MU: [50%, 75%), SU: <50%.
• SO: >=115%, MO, FV, MU: [50%, 115%), SU: <50%.

The total US stock market valuation is based on Wilshire 5000 index while the GNP is based on Federal Reserve's quarterly released number. From 12/31/1980 to 9/18/2009, the weekly adjusted portfolio achieves 8.648% annualized return and standard deviation 12.2% compared with Wilshire 5000 total return's annualized return 7.4% and standard deviation 17.5%.

It is even more amazing if an investor opted to invest only when the market was significantly undervalued and went to cash when the market became significantly overvalued. Such a strategy would keep an investor in cash from 2/27/1998 to 3/6/2009: avoiding the last two bubbles altogether!  The following figure shows the transactions:

Such a portfolio achieves annualized return 9.71% with standard deviation 11.4% from 12/31/1980 to 9/18/2009. There are only 3 transactions during this whole 29+ year period.

On last Friday (9/18/2009), the Buffett Indicator stood at 77.5%,  valuing the US stock market as Fairly Valued if one uses the 5 categories above.

Along with Buffett Indicator, ValidFi recently introduced various financial, economic and sentiment indicators. Interested readers could find up to date information of these indicators on ValidFi's 360 Degree Market View page.

Market Timing Strategies Based on Financial and Sentiment Indicators

Market timing strategies have been controversial: academics published many studies in this subject and most of them concluded that it is useless to pursue market timing. On the other hand, practitioners have been using this for many years (explicitly or implicitly). In a paper published by Neuhier and Schlusche in Feb. 2009, titled as Data Snooping and Market-Timing Rule Performance, the study examined stock market timing strategies based on various combinations of financial and sentiment indicators. The paper's conclusion is mostly negative on those strategies based on historical simulation during the period from 1981 to 2007. With the recent market upheavals, it is interesting to revisit these strategies by including the period since 2007 to now.

The basic idea behind these strategies is to remain invested in the stock market when expected returns are high and switch to cash investments when the market is expected to underperform. Investors long securities but temporarily exit the market and switch to holding cash in bad times based on certain timing indicators. By avoiding exposure to stock market during the weakest months and being long during the rest of the time, one would hope to reduce risk and achieve a reasonable return. The key to measure the performance of these strategies should include the risk factors such as maximum drawdown (measured as the maximum from a peak to a following trough percentage), standard deviation and Sharpe ratio (the so called risk adjusted return).

ValidFi recently released various stock market timing strategies based on the description from the paper. These strategies and their model portfolios are now lively monitored on validfi.com. These strategies employ the following indicators:

• Financial indicators
  
  • Earning to price: essentially this is the S&P 500 PE ratio.
    
  • Dividend yield: this indicator is tracking S&P 500 companies' aggregate dividend yields in the past 12 months.
    
  • Dividend payout ratio: S&P 500 dividend payout ratio.
    
  • Bond to equity: the relative bond yield and earning yield relationship. The so called Fed model is one version of this.
• Interest rate indicators
  
  • Long term interest rate: based on long term Treasury bond yield. This indicator is sensitive to long term inflation expectation.
    
  • Short term interest rate: based on short term Treasury bill yield.
    
  • Maturity spread: the difference between long term and short term bond yields.
    
  • Credit spread: the difference between high yield (junk) bond and the investment grade corporate bond yield. The bigger the spread, the higher investors' risk appetite is.
    
  • Expected inflation: difference between nominal and real interest rate.
• Sentiment indicators
  
  • CBOE equity put/call ratio: the short term total equity put volume over the short term total equity call volume.
    
  • CBOE S&P 500 implied volatility VIX: the implied volatility of short term option contracts on S&P 500 index. This indicator is also called 'fear factor'.

In these strategies, several threshold values of the indicators are considered. They are either a historical value, such as the moving average or a certain percentile or a fixed number. Other parameters include delay days (number of days waited to take an equity position after a switching signal) and waiting days (minimum number of days to keep a position after switching).  The model portfolios have various parameter settings. In general, we find using SMA30 or SMA120 (30 or 120 days Simple Moving Average) are the most natural ways to set the parameters even though they might not be the best parameters.

The following table illustrates the performance of these strategies with the best parameter settings. From the table, one could see that financial indicator long term interest rate, interest rate indicator credit spread and the sentiment indicator put/call ratio have the best Sharpe ratios in the period monitored. The long term interest rate, being sensitive to the economic condition, surprisingly has an excellent predictive effect since 1963. On the other hand, the expected inflation based strategy has quite a bit under performance. We believe it might be due to the inaccurate estimate methodology used.

Table 1: The Best Performance Portfolio of Each Market Timing Strategy

(From start date to 9/9/2009)

Timing on S&P 500 Index Timing Timing Buy and Hold S&P 500 Index (dividend is not reinvested) Buy and Hold Buy and Hold Indicator Parameters AR Sharpe Start Date AR Sharpe Long Term Interest Rate SMA30, 5, 5 9.58% 0.481 4/1/1987 5.78% 0.148 Short Term Interest Rate SMA30,1,1 4.82% 0.081 1/1/1963 6.16% 0.142 Maturity Spread SMA30, 5, 5 3.37% -0.041 1/1/1963 6.16% 0.142 Earning to Price SMA30, 1, 1 6.27% 0.271 1/1/1990 5.60% 0.158 Dividend Yield SMA30, 1, 1 3.26% 0.053 1/1/1990 5.60% 0.158 Bond to Equity SMA30, 1, 1 6.54% 0.253 1/1/1990 5.60% 0.158 Dividend Payout Ratio SMA120, 5, 5 6.57% 0.307 1/1/1990 5.60% 0.158 Credit Spread SMA30, 1, 1 8.53% 0.404 1/1/1997 2.66% 0.019 VIX SMA30, 5, 5 4.17% 0.137 1/1/1991 6.29% 0.201 Expected Inflation SMA30, 1, 1 1.72% 0.004 1/1/2003 2.44% 0.035 Put/Call Ratio SMA30, 5, 5 7.54% 0.377 1/1/2004 -1.28% -0.137 Learning 256, 256 5.85% 0.237 1/1/1990 5.60% 0.158 Voting 0.6, 1 month 4.22% 0.107 1/1/1990 5.60% 0.158

In addition to the live strategies mentioned above, ValidFi also maintains a 360 degree market view page to monitor various indicators and most asset classes trends.

This article only serves as an introduction to the above strategies. We will have more follow up articles to discuss individual strategies in more detail.

Recent Gurus' Asset Allocations

With summer fading away, we now suddenly find ourselves in September, one of the worst months for the stock market. It is thus a good time to check up your portfolio and make necessary adjustments if it is necessary.

In the previous article, we introduced ValidFi's Guru Asset Allocation Watch and strategies. The Guru Asset Allocation Clone strategy applies ValidFi's proprietary algorithm to detect a mutual fund's asset exposure and utilizes the derived information to make necessary asset allocation decision for each month. The risk adjusted performance of the strategy is fairly impressive for the past ten years. Readers could examine one of its model portfolios for more information.

The portfolio recently made a noticeable asset allocation change on August 31st. 2009. The following table compares its August and September allocations (notice that the funds used to represent the asset classes could be replaced by ETFs such as SPY, EFA, IYR, TIP, CIU or CFT, BWX, EEM, HYG or JNK and BND or AGG).

Asset	August Allocation	September Allocation
VBMFX	0.00%	0.00%
VFISX	20.47%	0.00%
VWEHX	0.56%	2.31%
VEIEX	3.50%	5.08%
TGBAX	10.25%	0.00%
VFICX	15.09%	46.52%
VIPSX	10.80%	27.98%
VGSIX	0.03%	0.06%
GLD	0.00%	0.00%
VGTSX	2.96%	1.96%
VFINX	36.34%	16.08%
Stock Exposure	42.83%	23.18%

From the above table, the most noticeable changes are:

• Total stock exposure: reduced from 42.83% to 23.18%
• Fixed income allocation: big increase to Investment Grade Corporate Bond (VFICX) and Inflation Protected Treasury Bond (VIPSX)

The September allocation is very defensive.

Let us further examine the recent allocation moves for several top performing allocation funds.
The following picture illustrates Vanguard Wellesley Income Fund (VWINX). We could see the fund made noticeable reduction in equity exposure during August.



The other top allocation fund, GMO Benchmark-Free Allocation GBMFX has the following allocation trend:



Again, the fund made equity reduction during the August time frame.

Readers are encouraged to take advantage of the ValidFi's Real Time Asset Allocation tool to find out asset allocation trends of your favorite funds. It is free but requires a registration during its Beta testing period.
To summarize, several great asset allocation investors have made a very defensive move. Even if you don't want to change your asset allocation right now, it pays to keep an eye on this.

Benefiting from Simple Hedging Techniques (Part II)

In the previous article, we discuss a simple hedging technique. In this part, we will discuss more effective ways to hedge.
A natural way to improve hedging technique is to use timing indicators as the guide to hedge or unhedge. Moving averages are one of the simplest and effective indicators. Using moving averages, one could start to short the chosen index ETF when the indicator gives a sell signal and then buy back the ETF when the indicator gives a buy signal. ValidFi's Momentum Hedge is a very good example to show that by using such a simple technique, one could achieve a reasonably good return while reducing the risk dramatically. In this strategy, a portfolio based on Sector Rotation Fidelity Select Funds strategy is used as the long portion of the portfolio while short position on SPY is taken based on whether SPY price is lower than the 130 days EMA (Exponential Moving Average) or 200 days SMA (Simple Moving Average). The following is the comparison of the long only portfolio and the hedged portfolio using 130 days EMA up to 9/1/2009.

		Last 1 Year (%)	Last 3 Year (%)	Last 5 Year(%)	Since 12/31/1993 (%)
Annual Return	Long Only	-11.83	-0.51	11.62	16.01
	Hedged	27.6	8.6	15.4	13.8
Sharpe Ratio	Long Only	-32.3	-7.6	35.69	55.07
	Hedged	120.5	32.1	62.7	51.3
Standard Deviation	Long Only	37.2	29	27	24.7
	Hedged	22.7	21.3	21.4	22.1
Maximum Drawdown	Long Only	34.9	47.5	47.5	51.1
	Hedged	13.9	20	20.4	49.6

Notice that maximum drawdown for the hedged portfolio improved in the last 1, 3 and 5 years but it has a huge 49.6% maximum drawdown since the inception date. This occurred during 2000-2001 period. This offers a cautious tale to hedge against a momentum driven portfolio: there might be still a period of time where some mismatched performances between the long and the short portions of the portfolio could be way too high to be tolerated.
Yet another way to hedge is to always short so called weak assets (or sectors) with a corresponding or a lesser amount. When shorting with equal amount as the long portion's, this is often called zero cost hedge as in theory (and for large institutions), the brokers would use the borrowed amount from the short sale to offset the long amount used. In ValidFi's Global Tactical Asset Allocation Momentum strategy, based on the original paper suggested, 100% short amount is used to short the worst performing three assets based on their past price performance while in the meantime keeping a long portfolio on the best performing three assets. For example, at the moment, the long part of the portfolio consists of VUSTX, GLD, VWEHX and the short part of the portfolio consists of VGSIX, VIMSX and VGTSX. Notice in this portfolio, we use index funds as the shorted indexes. In practice, one should substitute the above using ETFs equivalent. That would translate into long TLT, GLD, HYG and short IYR, MDY and EFA. The result is a mixed bag as one could see from here.
It should be noted that aside from the hedging, one could always perform tactical asset allocation (such as reducing or increasing the risky asset exposure) to avoid taking short positions. It is a simpler solution. The main reason to hedge instead of reducing the risky asset exposure by selling has to be that one believes the long portfolio could outperform the shorted index(es) during the possible market downturn. If this does not hold or it is hard to justify such an out performance, reducing or liquidating the positions is a better choice. The pros and cons should be weighed carefully.
One notable mutual fund which performs long and hedging is Hussman Strategy Growth Fund (HSGFX) managed by John Hussman. For anyone who is interested in the hedging techniques and Dr. Hussman's view point on current economic and market conditions, his weekly comments offer wealth of educational and prescient information.
In conclusions, some simple hedging techniques could go a long way to protect your capital while enhancing returns. In the current economic conditions, it is worthwhile to pay attention to them.