By Jack Forehand, CFA, CFP® (@practicalquant) —
Harvesting premiums in investing is a very challenging task for two main reasons. First, to capitalize on a premium, it has to exist. And we never know for sure whether a premium that exists in the historical data will exist in the future. And second, even if it does exist, the process of benefitting from it is often a very difficult one that involves suffering significant pain along the way.
To illustrate this, think about the value premium. It clearly exists in the historical data and the likelihood is that it will continue to exist going forward. But likelihood doesn’t mean certainty. There is certainly a version of the world in the future where the value premium will not exist. Value investors accept that risk when they try to take advantage of it. In addition to that, even if there is a value premium going forward, there still likely to be long periods where it does not exist. I certainly don’t have to remind anyone who invested in value in the past decade about that.
So although I am a big believer in value, there is certainly room for debate as to whether attempting to harvest the value premium is a good idea for your average investor. And that is true for most other premiums as well.
But there is one premium that is different. There is one premium that I don’t think much of a case exists against trying to access it. There is one premium that even index investors can benefit from. And you only have to do one thing to take advantage of it: rebalance your portfolio.
The Magic of Rebalancing
In some ways, rebalancing is a way to capitalize on mean reversion. It involves removing money from assets that have gone up and adding to assets that have gone down. It is a real-world implementation of the buy low and sell high principle that all of us have been taught in our investing careers. But digging into the details shows the benefits of rebalancing can be both more powerful than most investors think, and more complicated to understand than an oversimplification like that.
To understand why this is, I will do what I often do in my articles, which is to rely on the work of someone much smarter than me. In this case, it will be Adam Butler of Resolve Asset Management. Adam wrote an excellent paper titled “Risk Parity: Methods and Measures of Success“. In an appendix to that paper, he looked at the benefits of the rebalancing premium.
Before we look at the rebalancing premium in detail, it is first important to understand a concept that many investors have a difficult time grasping. The concept is that the act of rebalancing a portfolio can actually lead to a greater return than the weighted average return of the assets within it.
In An article for Advisor Perspectives, Adam explains the rebalancing premium this way
I define rebalancing premium as the difference between the compound return on a portfolio, and the weighted average compound returns produced by the underlying investments in a portfolio.
Let’s use a simple example to illustrate this. Assume I have a portfolio with 3 assets, stocks, bonds and a tail risk strategy that is setup to protect from major market declines. A tail risk strategy is obviously not a common part of most investor’ portfolios and I am not advocating using one, but I included it because it is a great way to illustrate this concept.
Let’s say that I invest 50% of my portfolio in stocks, 40% in bonds, and 10% in the tail risk approach. Let’s also assume that stocks return 8% per year in the next decade, bonds return 3%, and the tail risk fund returns -1%.
If I gave you those returns in advance, would you own the tail risk fund? I would assume that most investors would say no.
But it is actually possible for that fund, despite its negative return, to increase the return of the stock and bond portfolio. And the reason gets back to the power of the rebalancing premium. Despite the fact that tail risk funds typically lose money over time, they are setup to produce massive returns during the stock market’s worst periods. For example, many were up hundreds of percent during the rapid Coronavirus decline. Because they pay the most when stocks perform the worst, they offer an opportunity for an investor to add large amounts of money to their equity positions when they are down the most. This ability to rebalance and add exposure around market lows means that they can actually enhance the returns of a stock portfolio, even though their long-term returns are significantly worse than stocks.
Adam looked at a more real-world example in his article by examining the Permanent Portfolio, which consists of stocks, treasury bonds and gold. He compared the weighted average compound returns of the individual positions within the portfolio with a regularly rebalanced portfolio using different time frames.
As you can see from the table below, the rebalanced portfolio outperformed the individual assets by 1.2% per year (i.e. the rebalancing premium row in the table below). That is a significant boost in performance for something as simple as regularly rebalancing.
|Weight Compound Return
Cumulative growth and performance statistics for Permanent Portfolio and constituent assets, 1982 – May 2020. SIMULATED RESULTS, source: The Rebalancing Premium in Risk Parity Portfolios – Articles – Advisor Perspectives
The Last Free Lunch in Investing?
Rebalancing is not perfect. Sometimes the same assets keep going up so rebalancing away from them can hurt short-term performance. Taxes and transaction costs can also be an issue, especially in taxable accounts. But in the long run I am not sure there is anything that offers a better combination of simplicity and effectiveness than rebalancing. It may be one of the last true free lunches in investing.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.