Rolling with the Punches to Buy Low and Sell High
Years ago, as he was preparing for his next title fight, a media scrum formed around boxing legend Mike Tyson. The questions were fairly standard, including how he planned to deal with his opponent’s style and how he would react to the flurry of right hooks sure to come his way. Never one to overthink things, the heavyweight champion simply responded with, “Everyone has a plan…until they get punched in the face.”
This straightforward quote is widely applicable to many aspects of life, but it takes on added significance when applied to investing. Even with the best laid, long-term investment plan in place, it is easy to get side-tracked when volatility spikes in the commodity, currency, stock or bond markets. However, the ability to stick with a reasonable, long-term investment strategy often matters more than the strategy chosen at any particular point in time.
Our commentary from August 2013 provided some supporting evidence. Reacting to recent results – which usually involved abandoning a certain strategy in favour of the latest “winning” approach – has historically produced sub-par long-term performance when it comes to both stock and bond investing.
With this in mind, one may ask how the contrary strategy performed. Specifically, how did rebalancing – where allocations to recent winners were trimmed in order to maintain a strategic asset mix – benefit portfolio performance?
An interesting finding came out of a recent study on so-called “smart beta” strategies. The main idea behind these approaches is that they use specific rules to improve upon a simple index fund methodology. For example, a high-dividend “smart beta” strategy may only select stocks in the index that have payouts above 3%. A low volatility fund might favour names in the market with the most price stability.
The study found that over different time periods and in different markets, a lot of these “smart beta” strategies outperformed the index. The counterintuitive result was that any specific method of picking stocks could work. A plan of just selecting stocks with the highest debt levels or the weakest sales growth could also outperform the broader index over certain cycles. The commonality in these strategies is that they were rebalanced at least annually, based on something other than price. While the index assigned higher weights to names that had recently moved up in price, these alternative strategies were adjusting the amount invested in each holding due to other characteristics.
However, before rushing out to invest in the latest “smart beta” strategy, we should keep in mind one of the caveats to these approaches: portfolio turnover. Frequent rebalancing leads to higher transaction costs and capital gains taxes. For some “smart beta” approaches, their outperformance over a simple index fund would be negated once these expenses are considered. For this reason, studies on portfolio rebalancing are akin to reports that show red wine and dark chocolate are good for your health. While the results may be true to a certain extent, it is certainly possible to have too much of a good thing.
The charts below highlight the results of a study T.E. Investment Counsel ran on various approaches to rebalancing. Assuming an asset mix of 60% Canadian stocks and 40% Canadian bonds, we looked at how rebalancing on a monthly, quarterly and annual basis affected portfolio results from February 2001 through December 2014. In addition, we examined a strategy that is closer to how our investment counsellors manage portfolios, where rebalancing took place when the portfolio was 5% away from the target asset mix.
As you can see, the buy and hold (or non-rebalanced) approach doesn’t result in any turnover, although market movements over the thirteen years caused the portfolio to move out of line with the recommended asset mix. Specifically, because the investment in Canadian stocks grew faster than the investment in bonds, the weight in stocks increased to over 70% of the portfolio. The implication was that the portfolio’s volatility also increased.
On the other hand, the bottom graph shows that monthly rebalancing results in a portfolio that stays closer to the target asset mix. However, to achieve this, the average annual turnover of the portfolio was 22%. This means that for a $1000 portfolio, on average $220 was moving from one investment to the other every year. While volatility was lower, in practice the return of this portfolio would have also been lower due to transaction costs.
The strategy of only rebalancing when the portfolio was 5% out of line with the strategic targets did well. Throughout various market cycles, the portfolio stayed in line with the target asset mix, though it did so without excessive turnover. Furthermore, this strategy resulted in lower volatility than the buy and hold strategy as well as a higher return.
In practice, inflows or outflows from the portfolio are also used as opportunities to rebalance. While investment cash flows were outside the scope of our study, the findings are instructive. A reasonable rebalancing strategy mitigates volatility while also enforcing a discipline to buy low and sell high. Though it may not work all of the time, sticking to a plan has shown the ability to work over time.