More...
617-529-2913
20 Adams Street | Suite 200 | Boston, MA 02129

Tag Archives: asset allocation

Asset Allocation Insights – The Seesaw Continues But Risky Assets Continue Winning

Weekly Asset Allocation Highlights

  • Risky assets recovered last week – it seems like every other week we flip around – maybe this week is going to be good for bonds?
  • Developed market equities did best this week with EAFE out-performing the US
  • EM equity and bonds recovered from pretty poor momentum – currency helped last week for a change
  • A 60/40 mix of purely US assets under-performed a global version but remains vastly ahead YTD
  • In general, higher risk multi-asset strategies out-performed last week and remain ahead YTD

Currencies:

  • The USD gave up a bit of ground last week
  • Foreign central banks are reading their way toward policy normalization
  • Within EM currencies the pattern was mixed – the Rand and Rubble recovered nicely but the Brazilian Real continued its downward slide
  • Among the major currencies, the euro outperformed
  • The Yuan has stabilized after a period of depreciation but remains volatile within the “official” range

Commodities:

  • Grains are getting whipsawed by trade war on/off issues – Corn and soybeans continue being most at risk
  • Coffee also keeps getting pounded by the depreciating Brazilian Real
  • Oil is also getting whipsawed by political tensions – up a little last week as curbs on Iranian oil take effect
  • Gold and Silver were stable last week for a change but barring a real crisis continue on a downtrend

This Coming Week:

  • Are political issues in Washington of any concern to markets? Is the Manafort plea deal the beginning of the end?
  • The strong USD keeps crushing investors in international assets but should be losing some momentum.
  • EM equities, in particular, are taking a huge hit both on the asset side as well as currency -China has a lot to do with this given its weight in the MSCI index (30%)
  • Growth is outperforming Value YTD but things may be turning around especially if interest rates remain range bound
  • Global Tech has performed well this year but short-term it is in a break Down phase. More bad news to come or buy the dip? We are holding steady, not buying more.
  • Gold and Silver are losing their luster – not providing downside hedge and very driven by trends in short-term rates
  • What will make investors price risk more in line with history? A growth scare in the US, maybe? A real inflation scare? Waiting for Impeachment?

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Asset Allocation Insights – It was a bad week for all of us, Mr. President

Weekly Asset Allocation Highlights

  • President Trump wasn’t the only one having a bad week – is this a Fake Correction?
  • Cash is king once again but our risk aversion index is not picking up any fear
  • US assets lost less last week if that is any consolation
  • International equities lost the most value last week
  • A 60/40 mix of purely US assets out-performed a global version once again
  • Lower risk multi-asset strategies out-performed last week and are ahead in the last month

Currencies:

  • The USD was range bound last week but continues in a technical Up Trend phase
  • Within EM currencies the pattern was mixed
    • The Rand continued depreciating while the Brazilian Real regained some ground versus the USD
  • Within the major currencies, the yen outperformed
  • The Yuan has stabilized after a period of depreciation but remains volatile within the “official” range

Commodities:

  • Grains are getting whipsawed by trade war on/off issues
    • Corn and soybeans continue being most at risk but regained some ground last week while Wheat continues deteriorating
  • Oil is also getting whipsawed by political tensions – down over 3% last week after several up weeks
  • Gold and Silver lost more ground last week and the trend is down especially as ST interest rates keep climbing higher

This Coming Week:

  • Is cash the new King?
    • Bonds and stocks are over-valued but growth still holding up which is positive for stocks but for how long?
    • We still prefer risky assets but are lowering risk at the portfolio level.
  • Are political issues in Washington of any concern to markets? Our risk aversion index is not picking up any concern at the moment.
  • The strong USD keeps crushing investors in international assets but should be losing some momentum.
  • International equities keep losing ground to US stocks despite superior fundamentals – becoming the contrarian play of 2018
  • EM equities, in particular, are taking a huge hit both on the asset side as well as currency
    • China has a lot to do with this given its weight in the MSCI index (30%)
  • Growth is outperforming Value YTD but things may be turning around especially if interest rates remain range bound
  • Global Tech has performed well this year but short-term it is in a break Down phase. More bad news to come or buy the dip? We are holding steady, not buying more.
  • Gold and Silver are losing their luster – not providing downside hedge and very driven by trends in short-term rates
  • What will make investors price risk more in line with history?
    • A growth scare in the US, maybe? A real inflation scare? Waiting for Impeachment?

 

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Asset Allocation Insights – Rewarding Risk Takers

Weekly Asset Allocation Highlights

  • Equities had again a big week last week as the market focused on growth again
  • US assets once again dominated non-US assets as the US dollar regained some lost ground
  • US REITS have continued their comeback after falling apart earlier in the year
  • Commodity index composition is playing a big role as divergences among commodities are accentuated
  • A 60/40 mix of purely US assets slightly out-performed a global version
  • Higher risk multi-asset strategies out-performed last week

Currencies:

  • The USD was flat last week
    • Down against developed market currencies but up against em currencies
  • Within EM currencies the pattern was mixed
    • The Rand depreciated over 2% while Rubble and Brazilian Real continued in a downtrend
  • Among the major currencies, the US dollar lost the most ground versus the Swiss Franc
  • The Yuan has stabilized after a period of depreciation but remains volatile within the “official” range

Commodities:

  • Grains are getting whipsawed by trade war on/off issues
    • Corn and soybeans continue being most at risk
  • Oil is also getting whipsawed by political tensions but had an up week due to smaller inventories in the US, robust Chinese demand and output curbs in Iran
  • Gold and Silver lost more ground last week and the trend is down especially as ST interest rates keep climbing higher
  • The large fall in coffee prices last week was again blamed on the falling Brazilian real

This Coming Week:

  • Still watching the USD – crushing investors in international assets but should be losing some momentum
  • International equities keep losing ground to US stocks despite superior fundamentals
  • EM equities, in particular, are taking a huge hit both on the asset side as well as currency
    • China has a lot to do with this given its weight in the MSCI index (30%)
  • Growth is outperforming Value YTD but things may be turning around especially if interest rates remain range bound
  • Gold and Silver are losing their luster – not providing downside hedge and very driven by trends in short-term rates
  • What will make investors price risk more in line with history?
    • A growth scare in the US, maybe? A real inflation scare?
  • Macro Events: Manufacturing (JP, UK, Germany, US), Trade Balance (US, China), lots of Fed Governor Speeches

 

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Asset Allocation Insights -Rewarding Growth Assets

Weekly Asset Allocation Highlights

  • Equities had a big week last week as the market focused on growth again
  • International assets dominated US assets as the US dollar lost some ground
  • EM stocks, in particular, had a good week, up 2.7%. Very little was currency related
  • European developed market equities also had a big up week (2.5%)
  • REITS had been slowly recuperating but last week they suffered a setback
    • Their behavior has recently become more aligned/correlated with equity markets so the poor performance comes as a surprise
  • A 60/40 mix of purely US assets vastly under-performed a global version
  • Higher risk multi-asset strategies out-performed last week

Currencies:

  • The USD lost some strength last week
  • Within EM currencies the pattern was mixed
    • The Rand appreciated over 2% but the real lost close to 5%
  • The Rubble continues imploding despite a jump in oil prices
  • Among the major currencies, the US dollar lost the most ground versus the Euro followed by the Pound
  • The Yuan has stabilized after a period of depreciation but remains volatile within the “official” range

Commodities:

  • Grains are getting whipsawed by trade war on/off issues
    • Corn and soybeans continue being most at risk
  • Oil is also getting whipsawed by political tensions but had a big up week due to smaller inventories in the US, robust Chinese demand and output curbs in Iran
  • Gold and Silver recovered a bit last week but the trend is down especially as ST interest rates keep climbing higher
  • The large fall in coffee prices last week was blamed on the falling Brazilian real – expect a reversal this week

This Coming Week:

  • Watching the USD – crushing investors in international assets but should be losing some momentum
  • International equities keep losing ground to US stocks despite superior fundamentals
  • EM equities, in particular, are taking a huge hit both on the asset side as well as currency
    • China has a lot to do with this given its weight in the MSCI index (30%)
  • Growth is outperforming Value YTD but things may be turning around especially if interest rates remain range bound
  • Gold and Silver are losing their luster – not providing downside hedge and very driven by trends in short-term rates
  • What will make investors price risk more in line with history?
    • A growth scare in the US, maybe? A real inflation scare?
  • Macro Events: Case-Shiller, US GDP, Japanese & German Inflation, rig count in US, Chinese PMI

 

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Asset Allocation Insights – The US Dollar is Killing my Best Ideas

Weekly Asset Allocation Highlights

  • The out-performance of domestic assets continued last week
  • A 60/40 mix of purely US assets vastly out-performed a global version
  • REITS had been slowly recuperating but last week they really took off
    • Their behavior has recently become more aligned/correlated with equity markets
  • International stocks continue under-performing despite cheaper valuations
    • EAFE in local currency is outperforming by 3.33% YTD
    • EM in local currency is outperforming by 5.13% YTD

Currencies:

  • The USD keeps chugging along notching weekly wins
  • EM currencies continue their pattern of depreciation
  • The biggest loser was the SA Rand – concerns over slower economic growth was a driver as well as contagion from the Turkish Lira
  • The rubble has stabilized but for how long?
  • The YEN was up slightly last week as monetary policy is likely to normalize soon in Japan

Commodities:

  • Grains are getting whipsawed by trade war on/off issues
  • Oil is also getting whipsawed by political tensions between the US and Iran – technicals are deteriorating
  • Gold and Silver continue a down-trend with little sign of relief especially as ST interest rates keep climbing higher
  • Lumber prices have become incredibly volatile and subject to trade issues between CA and the US

This Coming Week:

  • Watching the USD – crushing investors in international assets
  • International equities keep losing ground to US stocks despite superior fundamentals
  • EM equities in particular are taking a huge hit both on the asset side as well as currency
  • Growth is outperforming Value YTD but things may be turning around especially if interest rates remain range bound
  • Gold and Silver are losing their luster – not providing downside hedge and very driven by trends in short-term rates
  • What will make investors price risk more in line with history? A growth scare in the US, maybe? A real inflation scare?

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Asset Allocation Insights – Domestic Assets Keep Outperforming

Weekly Asset Allocation Highlights

  • The out-performance of domestic assets continued last week
  • A 60/40 mix of purely US assets vastly out-performed a global version
  • US small cap stocks had an up week as well as US bonds
  • REITS had been recuperating but last week was a setback despite steady US rates
  • International stocks continue under-performing despite cheaper valuations

Currencies:

  • The USD keeps chugging along notching weekly wins
  • EM currencies continue their pattern of depreciation
  • The rubble had an especially tough week as further US sanctions are taking a bite
  • Among the majors, sterling took the biggest hit despite an increase in ST rates
  • Second big down week in a row for pound

Commodities:

  • Grains are getting whipsawed despite presidential assurances of price supports
  • Oil is also getting whipsawed by political tensions between the US and Iran
  • Gold and Silver continue a downtrend with little sign of relief especially as ST interest rates keep climbing higher
  • Lumber prices are breaking down due to over-valuation and a possible dispute with Canada over newly imposed tariffs

This Coming Week:

  • Q2 earnings in the US almost done – good season for most, good US growth
  • Watching the USD – huge effect on international markets especially
  • International equities keep losing ground to US stocks despite superior fundamentals
  • Growth keeps outperforming Value – turning point might not happen unless expectations for rising rates stabilize
  • Watching agricultural commodities for trade war effects

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Asset Allocation Weekly Insights

Weekly Asset Allocation Highlights

  • The out-performance of domestic assets continued last week
  • A 60/40 mix of purely US assets vastly out-performed a global version
  • US large and small cap stocks had an up week but REITS were the standout performer
  • REITS have been all year moving along with rates but recently their correlation to equities has increased
  • EM stocks continue having a rough year

Currencies:

  • The USD keeps chugging along notching small weekly wins
  • EM currencies continue their pattern of depreciation
  • Among the majors, sterling took the biggest hit despite an increase in ST rates
  • The yuan continues depreciating in a controlled fashion

Commodities:

  • A week of recovery for grains as President Trump has offered assistance
  • Wheat is least affected by global trade fears and has continued on a solid Up Trend
  • Gold and Silver continue a downtrend with little sign of relief especially as ST interest rates keep climbing higher
  • Lumber prices are breaking down due to over-valuation and a possible dispute with Canada over newly imposed tariffs

This Coming Week:

  • Q2 earnings in the US almost done – above average earnings season
  • Watching the USD – expecting some depreciation as other central banks start their normalization plans
  • Expecting momentum as a factor to start losing effectiveness – last week saw a resurgence of value and yield-oriented strategies
  • In the US the key macro number to watch is the CPI – expect a further slow rise
  • GDP releases in Japan and England, in China we are expecting Trade Balance numbers as well as CPI

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Key Asset Allocation Insights – Weekly Review

The Week In Review

  • Asset allocation strategies came under attack last week as global capital markets saw the period of extreme calm come to an end
  • Between the “memo”, earnings week and Super Bowl preparations there was a lot going on
  • None of the key asset classes that we use in our asset allocation process escaped the increase in investor risk aversion. Volatility really spiked up on Friday
  • The Fed did not hike rates at Janet Yellen’s last meeting as Chair but did raise the specter of inflation
    We have been in the camp that believes that investors have been underpricing inflation risk
  • Three huge US companies (JP Morgan, Berkshire Hathaway, and Amazon) are planning to launch their own health care network. Nobody has found the cost-containment magic. Maybe self-insuring and pooling “healthy” employees is the way to go

Key Asset Classes:

Last week saw the best performing asset classes of last year take the biggest hit

Asset classes across the board suffered losses. Diversification only lessened the blow

 

 

 

Emerging markets still remain in an UP TREND but profit-taking may have set in

Interest sensitive asset classes are firmly entrenched in Down Trends

 

 


Currencies:

The USD keeps depreciating and the Trump administration seems to favor this trend

A weak USD should provide a boost to commodity prices

A weak USD also makes imports more expensive further boosting inflationary pressures

In my view, USD depreciation is a function of political turmoil in DC

Higher short-term rates in the US provide a floor to the USD – don’t expect massive USD depreciation


Commodities:

In a week where news outlets told us that investors once again became fearful of inflationary pressures, commodities did not fare well

I am a bit skeptical that the reason the equity market got clobbered was a realization that inflation was a problem

I still think that inflation risk is underpriced by investors, but the stress in the equity market seems unrelated to commodity prices

 


Investor Risk Aversion:

Our most recent Risk Aversion Index reading returned to the Normal Zone

On a 4 week moving average basis, the reading is still in the Euphoria Zone

Prior weeks readings have been extraordinarily low indicting great investor complacency

 

We expect a risk on/off market in 2018 – Friday might have been the start of more normal risk levels


Chart of the Week:

Inflationary expectations are ratcheting up

Wage growth is the most cited reason, followed by a strong US economy

A weak USD is also at work

 

 

 


What We See This Week:

  • A bit more fear – I see a lot more risk on/off in 2018
  • Further profit taking – I think that investors know that 2017 was a gift from above
  • Taking some money off the table may be a smart move especially given valuation levels
    The money is likely to be deployed in cash, not bonds
  • Continued distaste for bonds as an asset class
  • Some recovery among healthcare stocks in the US – the JP Morgan, Berkshire Hathaway and Amazon venture will take time to crystallize
  • Lots of earnings – big companies reporting( Disney, Gilead, Tesla, Mondelez, GM, Allergan, Humana, Prudential, Cerner, Cummings, …)

Eric J. Weigel

Managing Partner, Global Focus Capital LLC


Services

Asset Management:

  • Tactical Asset Allocation
  • Global Long/Short Equity
  • Sustainable Equity

Consulting

  • Portfolio Reviews/Positioning
  • Risk Management
  • ESG

Research Publications

  • The Asset Allocation Advisor
  • The Equity Observer
DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Is Hope The Only Active Strategy Left?

There are so many stories going on in the press about the demise of the active management industry that one gets the impression that every portfolio manager must be feeling like a gambler pawning his last possession.

I recently attended a wealth management forum put together by Marketwatch were the commonly held view among attendees and panelists was that active management is dead and that the whole investment industry has been commoditized.

Certainly when evaluating security selection strategies relative to passively constructed benchmarks the recent record of active management leaves a lot to be desired. Times have been tough for active management shops and investors have been flocking to a myriad of index strategies. Exchange-traded funds (ETF) and multi-asset class strategies such as Target Date Funds have been the primary beneficiaries.

Barron’s magazine recently reported that only 33 percent of active equity managers managed to beat their benchmark last year. Outflows from actively managed strategies surpassed $288 billion (through November) – worse even than for 2008.

The popular S&P SPIVA report shows that the situation is not any better if one looks at a longer time period.  For example, as of June of 2016, only 8 percent of US large cap strategies managed to beat the S&P 500 index over the trailing five years.

Midcap and small cap managers did not fare any differently.  How about REIT managers? Not really – only about 11 percent of active strategies beat their index over the last five years.

International equity managers did fare a bit better than their US counterparts with close to 40 percent beating their index over the last five years.  32 percent of emerging market equity managers likewise beat their benchmark. A bit more hopeful but still nothing to write home about!

What about fixed income active strategies? A bit better in smaller pockets of the markets such as municipals, short and intermediate term investment grade where the majority of funds had higher returns than their corresponding index.

But among longer maturity strategies the situation was as abysmal as for equity managers. For example, only 3.5% of Long Government strategies outperformed over the trailing five years.  Even in the emerging market debt category only 8 percent of active strategies outperformed.

Is hope the only strategy left for the active investor? Just like the gambler down to his last pennies it sure feels lonely out there. All active management friends seemed to have slithered out the back door.

If the data cannot be tortured to confess, what about using theory to defend active management? Unfortunately, little help seems to be coming from the halls of academia.  Many years ago Bill Sharpe published his famous paper on “The Arithmetic of Active Management”.  The basic idea that active managers bear higher costs than passive investors thus creating a wedge in performance between the two has stuck as a reasonable theoretical explanation for the under-performance of  active management.

Recently, there has been some debate about some of the logic used by Sharpe (see the recent Lasse Pedersen paper) but in general while it is clear that index funds are not totally passive (due to new issues, repurchases, and index membership changes) the consensus still seems to be that the basic disadvantage of active management is due to its higher costs.

Another argument working against active management was espoused by another Nobel Prize winner Paul Samuelson even longer ago.  Samuelson held that the stock market is micro-efficient, but macro-inefficient. 

What this means is that at the level of individual stocks (where active managers ply their trade) it is much harder to beat the overall market but that the market itself may occasionally exhibit economically significant deviations from fundamental value.  Research by Jung and Shiller at Yale corroborates the Samuelson story of micro-efficiency and macro-inefficiency.

Every active manager knows that outperforming benchmarks is tough especially in a consistent manner.  A quote by Charlie Ellis of Greenwich Associates has stuck with me over the years. While I can’t remember the exact wording it goes something like this – “outperforming is difficult not because investors are stupid but because they are smart and compete with each other”.

I might have butchered Charlie’s quote but the basic idea is that with so many smart people participating in the markets today active management has become at least conceptually a zero sum game with the additional handicap of higher costs.

What this means is that on a capital weighted basis for every winner there must be a loser (assuming a fairly static market portfolio) but both must bear the burden of higher costs.  These costs are especially detrimental in an environment of lower capital market returns such as the one currently anticipated by Global Focus Capital.

Given all the evidence against active management what is the investor to do? Load up on ETF’s and run away from actively managed strategies?  The flow of funds data certainly seems to be confirming this behavior.  Active equity and bond managers have seen massive outflows to their strategies while flows to ETF’s have grown consistently for over ten years.

Continue reading

Sincerely,

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

 

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERROR

 

 

That Free Rebalancing Dessert Can be Costly!

dessert-1326898-638x428Rebalancing is a topic held near and dear to the heart of many investment advisors and often forms a key building block of what the advisor perceives as his or held value add.  If diversification is viewed as a free lunch then rebalancing is often viewed as free dessert.

Unfortunately while the benefits of true diversification stand the test of time the same cannot be said about rebalancing especially when done in a highly automated way such as frequently seen in many robo-advisor offerings.

What do we mean by rebalancing? There are many reasons why investment advisors intentionally shift the weights of their portfolio components over time.  The manager may have a changed view on future expected returns or they may deem a certain investment to now possess an unacceptable level of risk and thus wish to cut back on the exposure.  Others may wish to more closely track a commercial index and do a wholesale portfolio rebalance to minimize deviations from benchmark weights.

In general there are two basic underlying motivations for rebalancing.  The first is informational – the weighting structure of the portfolio is consciously changed to reflect an updated perspective on forward-looking estimates of return and/or risk.

The second basic motivation for rebalancing is purely driven by an automated rule that is agnostic to changing views on capital market risk and return conditions.  The rebalancing rule is followed religiously regardless of the capital market environment.

This second form of rebalancing and the focus of this note we refer to as a constant mix strategy.  Constant mix strategies take their cue solely from relative asset price changes over a chosen period of time and seek to bring portfolio weights back to a set of pre-defined time-invariant weights.

Why are many automatic constant mix rebalancing strategies viewed as a free dessert? Constant mix strategies trim relative winners and top up relative losers.  Assuming fairly priced asset classes at the beginning of the period a constant mix rebalancing approach can be construed as a value-oriented strategy buying up cheap assets and selling expensive assets.

The working assumption is that capital market forces will correct relative asset class mis-pricings.  Under this scenario markets are constantly displaying mean-reverting behavior.  Asset classes that go up must come down and vice versa.  Kind of a rollercoaster of relative performance.

Rebalancing programs will pick up nickels and dimes by selling relatively expensive assets and investing the proceeds into relatively cheap securities.  Transaction costs and short-term capital gain taxes will be incurred but according to proponents of such rebalancing programs, such costs will be offset by gains in portfolio values and as a side benefit – the icing on the cake – a reduction in portfolio risk. Risk in this context is frequently equated with downside volatility as valuation changes are viewed as the primary cause of mean reversion in asset prices.

The idea of buying low and selling high is alluring and under a mean reverting type of market a constant mix strategy would deliver on the promise. But the romantic notion of mean reverting markets often fades away as real capital market behavior with all of its flaws sets in.

Do real capital markets behave in the idealized mean reverting manner necessary for constant mix strategies to shine? Capital markets are ever changing as asset class fundamentals, risk characteristics and investor demand fluctuate for perfectly sensible as well as irrational reasons.  Capital markets are constantly calibrating supply and demand conditions and over short-term intervals changes in investor sentiment tend to overpower fundamentals.

There is also a lot of both academic as well as practitioner research on time series momentum.  In general the conclusion is that over intermediate time frames such as 12 to 24 months there are trends in asset class performance.  Mean reversion as a concept has been thought of more as a 3 to 5 year concept but over the typical time periods used in rebalancing programs (monthly or quarterly) the evidence is more consistent with trends in asset class prices.

Apart from taking advantage of mean reversion patterns in asset class performance how does rebalancing really work?  In a recent paper titled Rebalancing Risk, Granger, Greenig, Harvey, Rattray and Zou derive analytical formulas as well as provide empirical evidence on the behavior of constant mix strategies versus an approach that allows asset class weights to drift depending on relative performance.

In the paper they neatly decompose the performance drivers of the constant mix strategy.  What they show is that the constant mix strategy can be decomposed as follows:

Constant Mix Portfolio

=

Buy & Hold Portfolio

+

Selling Put and Call Options on Relative Asset Performance

The constant mix strategy carries negative convexity meaning that it outperforms when asset class return divergences are small by collecting the premium received for selling the puts and calls on the underlying portfolio.

However, when asset return divergences are large the selling of puts and calls results in losses and the buy and hold portfolio out-performs.  In extreme cases when one asset class significantly lags the rest of the portfolio such as in a stock market crash the negative convexity of the strategy can magnify the drawdown.

Another way to think of the constant mix strategy is to  put yourself in the shoes of the investor selling puts and calls.  When volatility rises holders of the options will benefit and commensurately sellers of options will see an economic loss. That is why the constant mix rebalancing approach is often described as a short volatility strategy.

The authors of Rebalancing Risk  conduct a set of empirical and simulation exercises using US stock and bond data. What do they find?

  • Constant mix portfolios exhibit small positive returns when relative asset class performance (stocks versus bonds in this example) do not perform too differently from each other.
  • When there are large differences in asset returns the tendency is to exhibit losses relative to buy and hold portfolios. The losses are magnified during periods of extreme relative performance.

The basic prerequisite for constant mix strategies to out-perform buy and hold strategies are reversals in asset class performance.  From a risk perspective, constant mix strategies add an element of risk as the approach involves additional option related features.  Justifying the use of a constant mix approach by implying risk reduction benefits is theoretically and empirically unfounded.

Access the full report here That Free Rebalancing Dessert Can be Costly!

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

HTML Snippets Powered By : XYZScripts.com