Rebalance of Power

by Craig L. Israelsen
University of Missouri-Columbia

From Financial Planning, magazine April 2002. Reprinted with permission.

ou can run, but you can't hide" probably describes the feeling many investors/advisors have had over the past two years. Account balances have dwindled, assets have shifted, and frustrations have mounted. Portions of the equity market gains, so generously provided in recent years, have been recalled. "The market giveth, and the market taketh away" is no longer a generalized notion, but a tangible reality. Clearly, many clients, and perhaps planners, got rather comfortable with the "market giveth" thing. Enter the "taketh away" angle and people feel betrayed. Clearly, taking the good with the bad requires perspective. Understandably, how we manage in the good and bad years can make a big difference in our perspective. Toward that end, this article examines the logistics and possible benefits of annual rebalancing as a portfolio management technique to be employed during good, and bad, years. But first, a perspective on perspective.

The clouding of the collective investor perspective was brought on by a simple problem": during the 9 year period from 1991 - 1999 investors in U.S. index funds (i.e. S&P 500 clones) experienced a perpetual party - negative annual returns just didn't happen. Assets in large cap index funds burgeoned. The average annualized return for the S&P 500 during that 9-year span was 20.9%. In fact, over the 18 year period from 1982 - 1999 there had only been one negative calendar year return for the S&P 500, and that was a meager loss of 3.3% in 1990. By the end of 1999, dropping money into an "Index 500" clone fund seemed like a no-brainer. And then by the end of 2001, S&P 500 index funds were no-gainers for two years straight. A long feast followed by season of famine.

The reality is (as you may have repeatedly chanted to your clients) that a diversified equity portfolio is the only sane approach in attempting to achieve risk-acceptable returns over time. But, having assembled a diversified portfolio, is the planner's work done? Not necessarily. This article addresses how a diversified portfolio might be "managed" (or rebalanced) and the potential benefits of doing so. As the past 2 years have surely shown, portfolio management is often a more pressing issue to clients during market downturns. And, unfortunately, many investors make portfolio adjustments that reflect knee-jerk emotion, rather than course corrections outlined by a pre-defined battle plan.

The term "rebalancing" implies a management protocol in which at the end of a certain time period (annually, for example) the amount of money in each asset within a portfolio is either equalized or brought back to a pre-determined percentage of the total portfolio. This is accomplished by withdrawing money from the asset(s) which performed best (or least poorly) and investing it into the account(s) of the asset(s) which performed poorest (or least best). Figure 1 demonstrates the process involved in annual rebalancing. As can be seen, it "forces" one to periodically "sell high and buy low." To avoid the burden of taxation in the current period, this approach is best suited for assets in tax-deferred accounts, such as IRA's, 401(k), or 403(b) accounts.

The portfolio in Figure 1 has an investor equally allocate money between large cap U.S. stock, small cap U.S. stock, and non-U.S. equities. The three separate assets had varying success in year 1 (using hypothetical results). The process of rebalancing at the conclusion of the first year required that $78 be withdrawn from the large U.S. stock account and $13 from the small U.S. stock account and invested into the international stock account, thus equalizing the amount of money in each asset at the beginning of year 2. This simple example represents one type of asset allocation model (or portfolio rebalancing strategy), which necessitates repeated portfolio allocation decisions, which are objective, rather than subjective. Objective is the key point here.

The particular portfolio being illustrated was chosen because of the moderate historical correlation between the three equity funds being considered. The 10-year correlation between each of the three funds is about .65. A coefficient of 1.0 indicates perfect correlation, such as would be the case between a S&P 500 Index fund and the S&P 500 Index itself. Assets with low correlation to each other tend to have contrasting performance from year to year. For example, the pistons of an engine do not all move in the same direction at the same time. It is precisely because the pistons fire in different order that the engine can produce power. In like manner, the contrasting performance of different assets from year to year can be beneficial in a portfolio.

We now examine the merits of annual portfolio rebalancing over a 25 year period (1977-2001) using three specific mutual funds (which represent three major equity classes): large cap U.S. stock, small U.S. stock, and non-U.S. stock. The mutual funds selected to represent these three assets were: Vanguard Index 500 (large US stock), Vanguard Small Cap Index (small US stock), and Scudder International S (non-US stock). These funds were selected because of their long return history and their high correlation with well-recognized benchmark indices. Vanguard Index 500 is, of course, a S&P 500 clone fund. Vanguard Small Cap Index tracks the Russell 2000 index, while Scudder International S closely tracks the Morgan Stanley Capital International World xUS Index (as well as the MSCI EAFE index). Historical performance data were obtained from Morningstar Principia Pro.

As shown in Figure 2, each fund produced an average annualized return in excess of 11% over the 25-year period. The highest average annualized return belonged to Vanguard Index 500 with an annualized return of 13.4%. Also shown in Figure 2, in the right-hand column, is a three-fund portfolio consisting of an initial allocation of 33% into Vanguard Index 500, 33% into Vanguard Small Cap Index, and 34% into Scudder International S. At the end of each year, the assets in three-fund portfolio were rebalanced back to the initial percentages using the technique shown in Figure 1. The three-fund portfolio with annual rebalancing achieved the second highest average annual return over the 25-year period and did so with significantly less risk (as measure by annual standard deviation of return) than the Small Cap Index fund or the International Stock fund.

One of the benefits of annual rebalancing is not likely to be return maximization. Rather, rebalancing generally reduces portfolio volatility. This benefit is particularly visible in the "Average Negative Return" of -5.6%. The three funds, when utilized separately, had average negative returns of between -7.5% to -8.4%. Vanguard Index 500 had only 5 negative years during the 25-year span while Vanguard Small Cap had 7, Scudder International had 8, and the three-fund portfolio had 8. Thus, the three-fund portfolio did not minimize the number of negative years, but lessened the magnitude of the negative returns. Interestingly, the three-fund portfolio tied for the lowest number of years with positive returns (17), yet had the second highest average "positive-year return" of 22.9%. Vanguard Index 500 had the lowest positive-year average return of 19.9%. Finally, the maximum and minimum annual return data at the bottom of Figure 2 reflect the essence of a balanced investment strategy - narrower performance parameters which lessen downside risk without sacrificing return.

Figure 3 presents yet another perspective, namely the cumulative account value from year to year. This dollar-based, account value view is often what drives client behavior, perhaps more so than annualized percentage return data. The three mutual funds in Figure 3 begin with a $1,000 investment. The three-fund portfolio (with annual rebalancing) was also started with $1,000, but divided equally across the three funds with $333 invested into Vanguard Index 500, $333 into Vanguard Small Cap Index, and $334 into Scudder International S.

We observe that the three-fund portfolio never had the highest balance (though close in 1995). However, it had the 2nd highest account balance in 20 out of the 25 years. A most interesting observation is the blocks of time which certain funds have the highest account balance. For instance, the small stock fund had the hot hand (as measured by account balance) from 1977 - 1984 (with one exception in 1978). From 1985 to 1995 it was the international fund with the highest account balance each year. Then, in 1996 the domestic large cap fund took over and, despite the sag in 2000 and 2001, held a sizeable advantage over the other two funds by the end of 2001. Not far behind Vanguard 500 was the three-fund portfolio.

It is instructive to note in Figure 3 that the investor in Vanguard Index 500 had to wait 20 years, until 1996, to have the highest balance. The idea that "all's well that ends well" may sound nice, but investors don't have the luxury of knowing the ending in advance and, as a result, often bail out before the good times roll. The performance of the S&P 500 is a classic example of this. By the end of 2001 Vanguard Index 500 was a clear winner, but only because of the "good times" in 1996-1999.

Another potential "client-based-perspective" is presented in Figure 4. In this table is shown the annual rise or fall in account value in each of the four accounts (three separate funds and the three-fund portfolio). Vanguard Index 500 had the highest average annual change, Vanguard Small Cap Index the smallest. The highest average positive change belonged to Scudder International S with the three-fund portfolio in a close second. The smallest average negative fluctuation was produced by the small cap fund with the three-fund portfolio again in second place.

Figure 5, in conclusion, presents a strong argument in favor of annual rebalancing. A $3,000 investment into the three-fund portfolio (with annual rebalancing) in 1977 produced an ending account balance of $60,825 versus a combined ending balance of $55,853 from a $1,000 investment into each fund separately (with no annual rebalancing). This represents a 9% higher ending account balance. Moreover, the weighted standard deviation of return over the 25 years for the three separate funds was 18.3% compared to a standard deviation of 15.1% for the three-fund portfolio. Thus, the annually rebalanced three-fund portfolio achieved a 9% higher ending account balance with nearly 18% less volatility. A portfolio, which integrates different assets and systematically rebalances them, can produce results, which are attractive to both planner and client.

Figure 1. The Mechanics of Annual Rebalancing

Figure 2. Annual Returns

(Fund with Highest Annual Return highlighted in Blue)

Figure 3. Cumulative Account Balances

(High Account Balance shown in Blue)

Figure 4. Annual Changes in Account Value (in $)

Figure 5. Benefits of Balance