Thursday, June 18, 2009

Portfolio rebalancing - it's all in the technique

A recent paper from Fund Evaluation Group brought up a couple of interesting concepts dealing with portfolio rebalancing. They show three types of portfolio allocation strategies and the effects on performance. This is not anything revolutionary, but their particular focus is on portfolio rebalancing in highly volatile markets.

They start with a simple buy and hold strategy with a liner return profile:

Then they discuss the Constant Mix (fixed allocations) approach such as this pie chart:

This is quite common in traditional asset management. But in order to keep the proportions fixed, you buy equities in a down market (equities become a smaller slice of the pie, so you need to buy some to get back to the right proportion) and sell in the up market. The performance profile looks something like this:

Of course this is an exaggeration as the actual graph looks more like the chart below, but it's useful for illustration purposes.

This type of rebalancing strategy outperforms in volatile mean reverting markets, but is a killer in trending markets. As the market was dropping, these managers kept buying, exacerbating their losses. Portfolio theorists argue that this works because you are "dollar averaging".

A completely opposite strategy deployed more by traders is the trend (or momentum) following strategy. It has the opposite result of underperforming in markets that revert to the mean (as one gets "whipsawed" in a trend reversal.) They refer to it as the Constant Proportion Portfolio Insurance. One begins to sell as the price drops to limit losses. This is equivalent to the portfolio insurance used in the 80s. It works in well behaved markets but breaks down when markets gapped (as people learned the hard way in 87). One would continue buying in uptrending markets escalating gains:

What's striking is that people often deploy these strategies instinctively without understanding the potential impact on the return profile. The most dangerous strategy is some combination of these. For example in an up trend people often keep buying (momentum strategy), then when the trend reverses they buy some more (fixed allocation strategy). And when they lose massively, they finally capitulate and sell (back to the momentum strategy) to realize losses.

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