For the second time in the last four years and the third time in about a decade, investment/pension committees have to cope with the effects of extreme movement in the market value of their portfolios. With large differences in returns between risky and ‘riskless’ asset class returns (i.e., a one-year return on Canadian equities of -12% and one-year return on long-term bonds of +9.8%), many committees will now find that in the absence of an automated regular rebalancing program, their asset mix could very well be outside the ranges allowed by their investment policy (or at the very least, materially different than the policy target weights).
In the current markets, there can be some temptation to stick with the protection and safety of a bond overweight. After all, the list of economic and market ailments is long and worrisome—individual views regarding the market, expert and non-expert alike, are more in line with Dr. Doom than Pollyanna. Yet committees must go about their jobs and make the tough decisions required of them—including looking at rebalancing their asset mix back to the policy targets.
Rebalancing in times like this often forces committees to do something uncomfortable: sell the best performing asset classes and buy asset classes that have likely experienced poor returns (i.e., equities in general and non-Canadian equities in particular). As such, a process can require committees to make painful decisions or, often, the decisions do not get made unless the processes are automated—taking emotion out of the equation.
In his book Pioneering Portfolio Management, famed chief investment officer David Swenson at Yale University notes, “Far too many investors spend enormous amounts of time and energy constructing a policy portfolio, only to allow the allocations they established to drift with the whims of the market.… Without a disciplined approach to maintain policy targets, fiduciaries fail to achieve the desired characteristics for the institutions’ portfolio.”
To not rebalance means you believe the asset class performance in one period (good or bad) will predict the future performance (i.e., “we are going to stick to our winners” rather than believe in reversion to the mean). In most asset classes, most of the time, it has been reversion to the mean that has been the dominant trend in investing. To quote Howard Marks from Oaktree Capital Management, “We cannot know how far the trend will go, when it will turn, what will make it turn, or how far things will then go in the opposite direction. But every trend will stop sooner or later. Nothing goes on forever. Trees do not grow to the sky.” Perhaps it is preferable not to spend too much committee time predicting the near-term future—or at least to recognize individual and committee limitations and temper any ‘bets’ made.
There is appeal in trying to time the markets, especially at an asset class level. As studies have shown, asset mix is the primary determinant of return. This implies that if you can place the correct over/underweight bets, there will be significant opportunity to add value over time. The issue becomes whether or not a part-time committee is an appropriate mechanism to try to add value in such a way. In effect, the committee will have to be right twice: they will have to pick the correct time to overweight a particular asset class and the right time to rebalance back to target (or to underweight). Though it is not impossible to do this well, the math is not on the side of the committee. For instance, if you can time the overweight decision correctly 70% of the time and the rebalance/underweight decision correctly 70% of the time, the combined probability of doing both of these correctly becomes 49%—worse than just following the policy in the first place. This is a simple example, but it does illustrate the deeper concept. It is also worth pointing out that actually being correct 70% of the time is no easy task.
Some can and will be able to add value this way and their results can be enticing to try and replicate (or purchase). However, these investors are often the ‘exception that proves the rule,’ which is that most investors, especially committees that meet quarterly or less frequently, are often not in the best position to add value through such tactical allocations.
Another argument that arises in such discussion relates to the fact that perhaps the committees should reevaluate their overall investment policy targets before rebalancing—after all, these are unprecedented times. In relation to the first point, an investment policy should act as your investment rudder and keel, both of which are necessary when you are in the eye of a storm. Attempting to make rational long-term decisions is difficult at the best of times, but in turbulent times committees run the risk of changing strategies and basing decisions on emotion rather than sound principles. The point when the last investor capitulates to the prevailing trend will be the exact point when that trend will reverse because there will be no more buyers (or sellers as the case may be). While reviewing the long term asset mix strategy for appropriateness is never a bad idea, it is usually better to chart a new course in calm waters than while you are in the storm itself.
On the second point—that these are unprecedented times—it may be helpful to look at the data further. The gyrations in equity markets of recent years have seemed extreme and certainly have had a negative impact on most investment portfolios. The September 2011 -8.7% return on the S&P/TSX Composite index ranks as the 17th worst monthly return in the history of the index (with data going back to 1956). As well, two of the 16 observations that were worse than September 2011 return include September 2008 (-14.5%) and October 2008 (-16.7%). These returns are fresh in investors’ memories.
However, looking at the data further, one cannot fail to notice that similar or worse one-month losses occurred in the 1990s, 1980s, 1970s, 1960s and 1950s. If you examine the U.S. equity market data (which goes back as far as 1926), you will also notice similar or worse one-month returns in the 1940s, 1930s and 1920s. In other words, though the players in the story will change, the general premise will not; equity markets can be, and often are, very volatile. There is nothing new under the sun.
When thinking about rebalancing in the current environment, committees might be wise to heed Warren Buffet’s investing maxim, “be fearful when others are greedy and greedy when others are fearful.” Most observers of the markets would recognize an increase in fear of late.
This article looked at the rebalancing issue from a macro, or big picture, perspective. Clearly there are many other practical issues that committees should examine in setting up and implementing a rebalancing procedure. These issues, along with some committee education concepts (including when rebalancing works well and when it does not) will be the topic of a future column.