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Rebalancing Beats Sector Rotation

By: Frank Armstrong

By: Frank Armstrong, III, CFP„¢, AIFA®

Jim Cramer is always amusing and sometimes thought provoking. He’s larger than life, exuberant, passionate, committed and never pulls his punches. As an investment advisor, I’d rank him right up there with Snooki of Jersey Shore.

Cramer’s recent remarks about contrarian investing got me to thinking. Surprisingly, in the context of what he said, I agree with him. He defines contrarian investing as sector rotation by fund managers in an attempt to beat the S&P 500 and uses the example of managers overweighting or underweighting financials. He’s his unequivocal that it’s a losing strategy.

A sector rotation strategy is an active manager’s bet against the efficient market based on a forecast of future events. Sometimes you will win, more often you will lose, and the highest probability is that you will underperform the broad market the more actively you fiddle with sector rotation. Paying a manager to fiddle with sector rotation adds additional costs which compounds your error and further reduces your returns. It’s not nice (or profitable) to fool with Mother Market.

Even worse, contrarian investing on an individual stock can be a disaster. Doubling down on a stock nobody else loves is an enormous risk. There is a reason everybody else is selling it. That stock may never recover or worst case can go to zero. Just ask Bill Miller how his strategy of doubling down on loser financial stocks worked out for his investors.

Of course, everybody else could be wrong. Occasionally they are. Or, a new unanticipated event turns a company around – think Apple (AAPL) – after the return of Steve Jobs). But, Apple like resurrections are very rare, and markets are efficient enough that betting against them on an individual stock is a low probability shot.

It’s interesting to note that as a loser stock works its sorry way to zero in an index fund its weight in the market is reduced. So the index fund never purchases any more of it. When it finally dies its weight in the fund is so small that it leaves little trace as it goes off into history.

Who notices when one star winks out in the Milky Way? Does anybody even remember the market impact the day that Kodak (EKDKQ), Eastern Airlines, or Global Crossing? In economic terms to the owner of an index fund, it’s a non event. Contrast this outcome to one where the investor doubled down on these out of favor stocks.

Contrarian Investing vs. Strategic Rebalancing

Now we come to the interesting variation: strategic rebalancing. While at first blush this sounds like a contrarian strategy, it’s not and it has been a consistently profitable strategy for long term investors.

Markets have a well documented tendency to revert to the mean. And they often move in different directions and with different magnitudes of change. Systematically rebalancing gives us the opportunity to actually profit from the world’s volatility.

Volatility in the world’s investment markets is a disconcerting fact of life. But, little as investors like it, volatility has a silver lining. A simple strategy of re-balancing your portfolio as the various parts vary pays handsome dividends.

As opposed to contrarian investing rebalancing is purely passive in that it doesn’t rely on a forecast. It simply seeks to return a portfolio to its investment policy guidelines rather than under or overweight a portfolio in a chosen sector. But, we will be selling global market winners to buy unappreciated markets. However, it’s strategic, continuous and incremental.

We know several things about the world’s equity markets:

  • Over time they have a strong upward bias.
  • In the short run they may be volatile. For all practical purposes these movements are random and therefore unpredictable.
  • They don’t go up forever (think tech and S&P 500 in the late 90s).
  • They don’t go down to zero (unlike single stocks like Enron, or Lehman).
  • They often move in different directions (low correlations) or different velocities.
  • Over the long haul, they outperform fixed income, but have higher volatility.
  • They exhibit a strong tendency to revert to the mean.
  • So, if you had a diversified global portfolio divided between equity and fixed income and the equity portfolio was further divided into 8 or 10 distinct markets with fixed allocations you might often observe the various parts bouncing around like so many crazed ping pong balls. Given the calming effects of diversification, the portfolio as a whole bounces less than its parts.
  • The random bouncing of the various parts is a good thing. It gives us the opportunity to systematically rebalance back to an appropriate target asset allocation as your portfolio fluctuates. This enhances total return while moderating risk. Rebalancing forces a policy of selling high and reinvesting the proceeds into underperforming markets. When a particular market soars, we take some of the gains off the table. When a segment underperforms, we augment our position there. Someday they will change places. When they do it provides us with an incremental gain over a strategy that doesn’t rebalance.
  • During periods when the various market segments move together, there is no opportunity to rebalance. For maximum benefit we would like to see the various segments bouncing a lot relative to each other. The lower the correlation between fixed income and equities, and/or between the various parts of the global equity markets, the higher the benefit to the portfolio.
  • For the strategy to work effectively, markets must continue to revert to the mean over time, and the world must not end. We expect both those conditions to be met. There is credible economic theory to support mean reversion, and after each financial crisis we have always muddled through our problems and eventually returned to a growth trajectory. This time it’s not different!
  • For maximum effectiveness the strategy should be exercised opportunistically and dynamically rather than on a fixed interval. Opportunities to profitably rebalance might be lost if the portfolio was only examined once a year. Suppose an asset class were to double during the first six months of the year, and then shrink back to its starting value at the end of the year.
  • The chance to make a very profitable trade would have been missed. So, we monitor the portfolios and trade whenever an asset class moves out of a predefined band. The band must be wide enough to avoid daily or trivial trading, and small enough to capture valuable opportunities (net of all costs for execution and taxes).
  • Frankly, this strategy is counterintuitive. It may disconcert some investors who can’t relate to selling the “good” performers and buying the “bad” performers. But, we can demonstrate that it adds considerable value over time.

 

As seen on Forbes.