Does factor investing only work if you rebalance?

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Jefferson
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Does factor investing only work if you rebalance?

Post by Jefferson » Mon Jul 15, 2019 8:11 am

Assume that factor based investing does actually produce superior returns over long periods of time. Would a lot of that return simply be taking advantage of relative volatility by rebalancing regularly to capture reversion to the mean?

When I started investing on my own, I followed Paul Merriman’s Ultimate Buy and Hold strategy. Last July, I started putting all new (stock) money into VTSAX and VTIAX (Vanguard Total US and Total international). At the time, I planned to keep tilting to certain factors thus way:

Total US - 40%
Total International - 20%
US small cap - 10%
US small cap value - 10%
Ex-US small cap - 10%
Emerging markets - 10%

Since this is a taxable account, I just added new money to achieve this. But now I’m there and I’m trying to decide whether to start buying factors again or to just keep buying the total market funds. Either way, I’m planning to keep the US/International ratio at 60/40.

I get the importance of rebalancing stocks/bonds and US/international. Is it vital for factor investing? Going further, is it in fact the whole point of factor investing?

If the answer is yes, how often should one rebalance? For now, I’m adding significant money monthly, so no selling would be necessary for a while. But it would eventually. And I’d rather decide this now than later.

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JoMoney
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Re: Does factor investing only work if you rebalance?

Post by JoMoney » Mon Jul 15, 2019 8:32 am

Jefferson wrote:
Mon Jul 15, 2019 8:11 am
... Would a lot of that return simply be taking advantage of relative volatility by rebalancing regularly to capture reversion to the mean?..
Doubtful. Especially in terms of being "a lot". Since the returns are mostly correlated with other stocks, even if there is a "rebalancing bonus" it would be minimal.
I don't believe anything extra from rebalancing should be expected, it does happen from time to time over very specific periods where the assets can be shown to have "mean reverted"... but over other periods when one asset has diverged and earned a lot more than another one there might actually be a rebalancing deficit from constantly taking money from the higher returning asset and putting it into the lower returning one netting less than the what the simple average of the unrebalanced assets would be.
The reason to rebalance is to maintain your "risk profile" and keep your exposure to risk(s) inline.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Forester
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Re: Does factor investing only work if you rebalance?

Post by Forester » Mon Jul 15, 2019 8:28 pm

You should keep doing what you're doing. If there's another decade like the 2000s you'll be glad you tilted.

bluquark
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Re: Does factor investing only work if you rebalance?

Post by bluquark » Mon Jul 15, 2019 9:50 pm

JoMoney wrote:
Mon Jul 15, 2019 8:32 am
The reason to rebalance is to maintain your "risk profile" and keep your exposure to risk(s) inline.
Agreed. I think the only relevant type of rebalancing is between stocks and bonds. I am happy to let my different categories of stock float with market cap (which indeed is what happens *within* the funds).

If you truly believe in a rebalancing premium, many "smart beta" products claim to offer it within funds, for instance RSP S&P 500 Equal Weight ETF (but, the fact that it's effectively a midcap fund unlike all other S&P500 funds explains most of its return difference).

MotoTrojan
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Re: Does factor investing only work if you rebalance?

Post by MotoTrojan » Mon Jul 15, 2019 9:53 pm

Holding diverse equity factors may yield a small rebalance factor but correlations are quite high; you'll find this works a lot better with something like a long-term treasury fund which historically has had low/negative correlation to equities and enough volatility to take advantage of it. While the factor funds may have a slight zig & zag rebalance effect, that is not the core principal of factor investing. Factors historically outperformed in isolation as a sole-holding.

stlutz
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Re: Does factor investing only work if you rebalance?

Post by stlutz » Mon Jul 15, 2019 11:33 pm

Depends if your factor investments beat the market or not. If the market returns 4%/yr for the next 20 years and SCV returns 7%, rebalancing will hurt your returns. If they both have equal returns over time, then rebalancing will help you out.

rascott
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Re: Does factor investing only work if you rebalance?

Post by rascott » Mon Jul 15, 2019 11:48 pm

Merriman did some back tested studies on rebalancing. Not ever rebalancing had the highest end portfolio amount....as you basically let the higher returning asset classes keep running. Who knows what the future will hold.

fennewaldaj
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Re: Does factor investing only work if you rebalance?

Post by fennewaldaj » Tue Jul 16, 2019 5:35 am

As was stated above I would expect it to help you a bit if returns were more or less the same. I ran a test for the last 15 years where returns were very close to the same. It did help but only a tiny bit (~0.06%).

https://www.portfoliovisualizer.com/bac ... total3=100

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Jefferson
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Re: Does factor investing only work if you rebalance?

Post by Jefferson » Tue Jul 16, 2019 12:42 pm

rascott wrote:
Mon Jul 15, 2019 11:48 pm
Merriman did some back tested studies on rebalancing. Not ever rebalancing had the highest end portfolio amount....as you basically let the higher returning asset classes keep running. Who knows what the future will hold.
Now that’s interesting!

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David Jay
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Re: Does factor investing only work if you rebalance?

Post by David Jay » Tue Jul 16, 2019 12:57 pm

Jefferson wrote:
Tue Jul 16, 2019 12:42 pm
rascott wrote:
Mon Jul 15, 2019 11:48 pm
Merriman did some back tested studies on rebalancing. Not ever rebalancing had the highest end portfolio amount....as you basically let the higher returning asset classes keep running. Who knows what the future will hold.
Now that’s interesting!
It should be expected - if you do not rebalance then your relative position in equity will grow faster than your relative position in fixed income.

The corollary is that your Asset Allocation will also change and become more risky. The primary reason to rebalance is to maintain the asset allocation at meets your needs, willingness and ability to accept risk.

If you could accept any level of risk, you could have started out at, say, 90/10 and done even better over your investing lifetime than starting at, say, 70/30 and “drifting” higher without rebalancing.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

rascott
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Re: Does factor investing only work if you rebalance?

Post by rascott » Tue Jul 16, 2019 1:35 pm

David Jay wrote:
Tue Jul 16, 2019 12:57 pm
Jefferson wrote:
Tue Jul 16, 2019 12:42 pm
rascott wrote:
Mon Jul 15, 2019 11:48 pm
Merriman did some back tested studies on rebalancing. Not ever rebalancing had the highest end portfolio amount....as you basically let the higher returning asset classes keep running. Who knows what the future will hold.
Now that’s interesting!
It should be expected - if you do not rebalance then your relative position in equity will grow faster than your relative position in fixed income.

The corollary is that your Asset Allocation will also change and become more risky. The primary reason to rebalance is to maintain the asset allocation at meets your needs, willingness and ability to accept risk.

If you could accept any level of risk, you could have started out at, say, 90/10 and done even better over your investing lifetime than starting at, say, 70/30 and “drifting” higher without rebalancing.

Sorry....to clarify....was only talking about rebalancing between equity asset classes.

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David Jay
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Re: Does factor investing only work if you rebalance?

Post by David Jay » Tue Jul 16, 2019 1:51 pm

rascott wrote:
Tue Jul 16, 2019 1:35 pm
David Jay wrote:
Tue Jul 16, 2019 12:57 pm
Jefferson wrote:
Tue Jul 16, 2019 12:42 pm
rascott wrote:
Mon Jul 15, 2019 11:48 pm
Merriman did some back tested studies on rebalancing. Not ever rebalancing had the highest end portfolio amount....as you basically let the higher returning asset classes keep running. Who knows what the future will hold.
Now that’s interesting!
It should be expected - if you do not rebalance then your relative position in equity will grow faster than your relative position in fixed income.

The corollary is that your Asset Allocation will also change and become more risky. The primary reason to rebalance is to maintain the asset allocation at meets your needs, willingness and ability to accept risk.

If you could accept any level of risk, you could have started out at, say, 90/10 and done even better over your investing lifetime than starting at, say, 70/30 and “drifting” higher without rebalancing.
Sorry....to clarify....was only talking about rebalancing between equity asset classes.
Same logic - if you had a slice-and-dice over the last 10 years, the Large US would have grown faster and would have an increased weighting as a result.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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vineviz
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Re: Does factor investing only work if you rebalance?

Post by vineviz » Tue Jul 16, 2019 2:22 pm

MotoTrojan wrote:
Mon Jul 15, 2019 9:53 pm
Holding diverse equity factors may yield a small rebalance factor but correlations are quite high; you'll find this works a lot better with something like a long-term treasury fund which historically has had low/negative correlation to equities and enough volatility to take advantage of it. While the factor funds may have a slight zig & zag rebalance effect, that is not the core principal of factor investing. Factors historically outperformed in isolation as a sole-holding.
+1

Long-only equity funds typically have such a high correlation with each other that the pure "rebalancing bonus" is quite small. A diverse group of equity funds generally has an average correlation of 0.60 or better.

Even if you had three completely uncorrelated equity funds (e.g. all three pairs had correlation = 0.00), the "rebalancing bonus" would be less than 0.2% per year on average and would still be negative about 40% of the time.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Taylor Larimore
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Listen to Jack

Post by Taylor Larimore » Tue Jul 16, 2019 2:25 pm

Jefferson wrote:I’m trying to decide whether to start buying factors again or to just keep buying the total market funds.

This is an easy decision if you believe Jack Bogle who knows more than any of us about investing.

Best wishes
Taylor
Jack Bogle's Words of Wisdom: "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- In my view, owning the market and holding it forever is the ultimate strategy for winners." -- "My preferred index fund happens to be the total stock market which includes large, medium, and small stocks."
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Does factor investing only work if you rebalance?

Post by abuss368 » Sat Jul 20, 2019 2:38 pm

I would expect factor investing (much like anything other strategy) to have it's days in the sun and also its days in the storm. For investors who commit to it long term, it may work. There is no way of knowing. And simply, past results does indicate future success.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!"

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