Passive Investing Beats the Markets

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Passive Investing Beats the Markets

Post by Rick Ferri »

Here is a new blog on Forbes that's sure to be controversial:

Passive Investing Beats the Markets

The article points to other works that I written, but the basic premise is that a buy, hold, and rebalance strategy using low-cost index funds and ETFs outperforms the markets nominally and on a risk adjusted bases when compared to active fund strategies, market timing strategies, and an index fund/ETF strategy that's buy, hold, and never rebalance, i.e. the return of "the markets."

I'll be post more data on why buy-hold-rebalance beats "the markets" in future weeks. For those who may be turned off by this claim, it's just the free lunch from Modern Portfolio Theory taken down to the Main Street level. :wink:

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Post by richard »

Of course low cost passive beats active. By definition a passive market index has the same return as active before expenses. Because passive is less expensive, it wins. In addition to expense ratios, active means more tax costs, trading costs, market impact costs, etc.

William Sharpe wrote the classic version of this. http://www.stanford.edu/~wfsharpe/art/active/active.htm
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Post by Rick Ferri »

richard wrote:Of course low cost passive beats active. By definition a passive market index has the same return as active before expenses. Because passive is less expensive, it wins. In addition to expense ratios, active means more tax costs, trading costs, market impact costs, etc.

William Sharpe wrote the classic version of this. http://www.stanford.edu/~wfsharpe/art/active/active.htm
The extension of this, often overlooked, is that regular rebalancing of low-cost index funds outperforms a buy, hold, and do nothing portfolio, which is "the market". You beat the market by being the market, and having the unyielding discipline to rebalance when you should. What we preach on this site is to use market matching strategies because that gives market returns less low fees. However, the actual results, if done properly and consistently, outperforms the markets.

I believe pointing out this fact will help more people come to the light.

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Post by pauliec84 »

"it's just the free lunch from Modern Portfolio Theory taken down to the Main Street level."
I am not sure which MPT you are talking about, but the MPT that I am familiar with says that the Market Portfolio is the point of tangency.

So if you "take MPT to the main street" this would mean you begin with the market weights of each asset, and keep the market weights of each asset. As assets rise and fall, their market weights rise and fall, so there is never any re-balancing.

I don't blame individuals for wanting to reblance to keep risk profiles constant, but MPT - specifically 2 Fund Separation - says that you keep the allocation of the risky portfolio constant and adjust your risk-free allocation to control your desired risk level.

Your claim that re-balancing within your risky asset allocations will increase risk/return profile may be right. But it is not MPT that makes this claim. It would be some sort of behavioral story. Your strategy is a departure from MPT.

Also re-balancing is costly (just like active management, granted less so)compared to a pure buy and hold, both from a tax vantage point and transaction cost vantage point. I HOPE this is taken into account when tabulating the results.
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Post by Rick Ferri »

pauliec84 wrote:Your claim that re-balancing within your risky asset allocations will increase risk/return profile may be right. But it is not MPT that makes this claim. It would be some sort of behavioral story. Your strategy is a departure from MPT.
I agree with you. So, what do you suggest we call this? A rebalancing benefit? A risk control benefit? A regression to the mean benefit? I don't know. The fact is, it happens. The returns are higher and the risks are lower than a buy, hold, and do nothing portfolio, i.e. the market. It needs to be called something smart and acedemic sounding. A "free lunch" doesn't cut it.

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Re: Passive Investing Beats the Markets

Post by Wagnerjb »

Rick Ferri wrote:the basic premise is that a buy, hold, and rebalance strategy using low-cost index funds and ETFs outperforms the markets nominally and on a risk adjusted bases when compared to active fund strategies, market timing strategies, and an index fund/ETF strategy that's buy, hold, and never rebalance, i.e. the return of "the markets."
Why don't you go one step farther in your next Forbes column and explain how tax management guarantees that you will outperform both active and passive strategies, on an after-tax basis?

You can begin with proper placement of assets into tax-advantaged accounts. Then you can cover tax loss harvesting and delaying realization of capital gains. As advanced topics you can mention minimizing dividend yield and donating appreciated shares.

That's a sure fire way to further enhance the after-tax returns from either a pure passive strategy or one with rebalancing.

Best wishes.
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Post by Beagler »

Rick Ferri wrote:
pauliec84 wrote:Your claim that re-balancing within your risky asset allocations will increase risk/return profile may be right. But it is not MPT that makes this claim. It would be some sort of behavioral story. Your strategy is a departure from MPT.
I agree with you. So, what do you suggest we call this? A rebalancing benefit? A risk control benefit? A regression to the mean benefit? I don't know. The fact is, it happens. The returns are higher and the risks are lower than a buy, hold, and do nothing portfolio, i.e. the market. It needs to be called something smart and acedemic sounding. A "free lunch" doesn't cut it.

Rick Ferri
I suggest we call it "the Ferri Effect." :D
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Post by pauliec84 »

Not much of a namer.

I feel like your strategy (which most BHers probably follow to some degree) tries to optimize investments in a world where all actors are not rational (rationality is assumed in MPT), and this irrationality leads to a non-(weak form) efficient market via systemic behavioral bias'. Along the lines of Robert Shillers notion that price movements are larger then underlying fundamental movements dictate.

Even within an EMH framework, there can be irrational actors, but the idea is that rational actors act to move against the irrational actors, creating a rational market on the whole.

So maybe your strategy tries to swim against the tide of these behavior bias', and investors like you are the rational actors who bring equilibrium to the market (and profit from the movement from irrationality to rationality).

A little Devils Advocate:
The one dangerous component of this is that you may get caught moving against what seems like an irrational movement, but is actually a new paradigm. I think Random Walk Down Wall Street has an example of people trading short term fluctuations in the longer term gold/silver ratio. Your basically doing the same thing, but instead of gold/silver, you have your different asset classes.

So this may be a bit of a picking up penny's in front of a steamroller activity.
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Post by Lumpr »

I think there is a typo in the fourth paragraph second word (should be "investing" not "invest"). Not being critical, just thought you might want to know.
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Post by Rick Ferri »

It think it could be called the "rebalancing benefit". Other's have already called it a "rebalancing alpha" (:thumbsdown I hate that phrase!).

Typo fixed! Thanks.

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Post by Avo »

Rick, did you really mean "1 in 3 actively managed mutual funds underperform their benchmarks over a 5 year period when adjusted for survivorship bias"? I thought it was 2 in 3.

More seriously, your evidence for a rebalancing benefit is 11 years of recent data???
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Post by Avo »

Also, over a long period of time, isn't it obvious that rebalancing will hurt absolute returns by moving assets out of the on-average faster-growing asset class??
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Hi Ric:

I enjoyed reading your latest Forbes article. I used your link at the end of the article to read this important passage in your book, The Power of Passive Investing.
The very reason budding academics such as William Sharpe, Eugene Fama, Michael Jensen, and Jack Treynor studied mutual fund returns in the 1960s was in an effort to discover managers who beat the markets and immolate their methods. Their efforts were largely unsuccessful back then, and new efforts by other academics since the 1960s have remained unsuccessful.

If the brightest Ph.D.s can’t figure out how to pick a winning manager, then it’s not likely that an individual investor or investment advisor is going to do it.
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Post by Epaminondas »

Is it possible to lose the rebalancing benefit by doing it too often (even assuming no transaction costs)? I am just curious because I was under the impression that I should not rebalance very week and instead only do once or twice a year.
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Post by Rodc »

I am not sure which MPT you are talking about, but the MPT that I am familiar with says that the Market Portfolio is the point of tangency.
These things are not all completely well defined but I think you are confusing MPT with efficient market hypothesis.

MPT is just weighted least squares: given the covariance matrix for a group of investments you can compute the optimal allocation.

One of the stronger versions of the EMH says that the market, without ever going through MPT calculations, will achieve this optimal mix.

While somewhat related, these are different things.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Post by pauliec84 »

Efficient Market Hypothesis refers to the information content of the market.

The foundation of MPT is mean variance optimization by the individual.
This is then built upon to show that the market portfolio is efficient. The idea is that that the mean-variance optimal portfolio will be held by all investors. Thus aggregating all individual investors holdings (which are M-V efficient, you get a market portfolio which is also M-V efficient).

Per Wikipedia:
"The above analysis describes optimal behavior of an individual investor. Asset pricing theory builds on this analysis in the following way. Since everyone holds the risky assets in identical proportions to each other—namely in the proportions given by the tangency portfolio—in market equilibrium the risky assets' prices, and therefore their expected returns, will adjust so that the ratios in the tangency portfolio are the same as the ratios in which the risky assets are supplied to the market. Thus relative supplies will equal relative demands. MPT derives the required expected return for a correctly priced asset in this context."

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Post by nisiprius »

Do we or do we not get a "rebalancing benefit" when we invest in a mutual fund that rebalances automatically, such as

Vanguard Balanced Index Fund (VBINX)
or the Vanguard Target Retirement funds

I realize that these invest in a smaller and tamer variety of asset classes than a typical "slice and dice" portfolio and therefore one might expect the benefit to be smaller; but is it there or not, and, if not, why not?
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Post by Rick Ferri »

Avo wrote:Rick, did you really mean "1 in 3 actively managed mutual funds underperform their benchmarks over a 5 year period when adjusted for survivorship bias"? I thought it was 2 in 3.

More seriously, your evidence for a rebalancing benefit is 11 years of recent data???
Fixed the error, thanks>

I have data going back 80 years. In most decades there is a nominal return benefit, and in every decade there is a risk-adjusted return benefit. Also, over a long period of time, stocks beat bonds, so a portfolio that not rebalanced will have more stocks will outperform eventually, but not on a risk adjusted basis.

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Post by pauliec84 »

David F. Swensen documented lower risk with same returns for Yale's portfolio following real-time re-balancing.
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Post by Rick Ferri »

The benefits derived from rebalancing asset classes has been known for a long time. This semi-active strategy reduces portfolio risk and increases returns in the long-term. Many people call the rebalancing premium the only "free lunch" on Wall Street. John Bogle writes repeatedly that markets regress to the mean over time, and this topic was a highlight in his first book, Bogle on Mutual Funds.

Australian Boglehead and investment advisor Travis Morien writes, "Regression to the mean is a powerful effect and is encountered everywhere in the man made world as well as nature...What regression to the mean implies is that you should never trust above average - or below average performance. You should never project trends to assume that high performance will be sustained. It is also just as dangerous to assume that when something is right down the bottom of the heap that it will stay there."

The case for disciplined rebalancing is a case for regression to the mean. This strategy has worked in that it has delivered higher nominal returns during most decades and higher risk-adjusted returns on all decades. I agree with pauliec84 above that this strategy is direct conflict with the efficient market theory and modern portfolio theory because those theories argue that the markets are correctly valued given information known today, and as such, regression to the mean shouldn't work.

I'm more concerned with efficient investing than efficient markets, and I'm with Jack Bogle on this one. Markets can become overly bearish or overly bullish. My problem is that I don't know when they are extended or oversold. This is where a disciplined rebalancing strategy helps. It forces me to sell high and buy low, even though I have no idea what high is and what low is.

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Post by Avo »

Rick Ferri wrote: This semi-active strategy reduces portfolio risk and increases returns in the long-term.
"Increases returns" compared to what, exactly??

You agreed above that if we start with a fixed allocation and let it run for many decades, not rebalancing has higher returns, because an ever higher percentage of assets is in the higher-returning category (stocks).

If you mean "increases returns on a risk-adjusted basis", then you should say so. IMO, this is very different than "increases returns".
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Post by pauliec84 »

Rick. This is very interesting.
I also really like nisiprius's point about the balanced funds. It would be interesting to look at the data and see if this effect turns up in the balanced funds (which I am sure it will).

One little technical point:
"Regression to the mean is a powerful effect and is encountered everywhere in the man made world as well as nature...What regression to the mean implies is that you should never trust above average - or below average performance. You should never project trends to assume that high performance will be sustained. It is also just as dangerous to assume that when something is right down the bottom of the heap that it will stay there."
It seems like quote is describing, mean reversion in the Ornstein–Uhlenbeck process sense. That a series of positive performance will make it more likely to have negative performance and vice versa. This is a negatively serially correlated process.

This is not to be confused with regression to the mean, is if you have a series of positive performance, going forward we will expect the long term average performance, and not necessarily good or bad performance. In this instance the process has zero serial correlation.

For what it is worth I found the following that supports your OP of stocks following a mean reverting process:
http://citeseerx.ist.psu.edu/viewdoc/do ... 1&type=pdf
For example, one currently popular hypothesis is that the stock-returns process may be described by the sum of a random walk and a stationary mean-reverting component, as in Summers (1986) and in Fama and French (1987).20 One implication of this alternative is that returns are negatively serially correlated for all holding periods. Another implication is that, up to a certain holding period, the serial correlation becomes more negative as the holding period increases.
It will also be interesting to see if this effect occurs within equity asset classes, or just for broader asset class distinctions like stocks & bonds. So at what level does it operate.
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Post by nisiprius »

pauliec84 wrote:It seems like quote is describing, mean reversion in the Ornstein–Uhlenbeck process sense. That a series of positive performance will make it more likely to have negative performance and vice versa. This is a negatively serially correlated process.

This is not to be confused with regression to the mean, is if you have a series of positive performance, going forward we will expect the long term average performance, and not necessarily good or bad performance. In this instance the process has zero serial correlation.
Thanks for making that point. I never heard the term "Ornstein-Uhlenbeck." (Never studied time series). I've been bothered for a long time as to whether financial writers mean the same thing when they use the terms "reversion" and "regression" to the mean. I find it very hard to believe there really is negative autocorrelation and compensation, although I do understand that that is what academics say, and that Siegel explicitly says so in Stocks for the Long Run--that the variance in total outcome over a long period goes down faster than the square root of the length of the period. I'd be a lot happier if someone could give some better reason why this should occur than "it just does."
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Post by pauliec84 »

Per the theoretical reasons I thought this footnote was interesting.
"Shiller and Perron (1985) propose only a mean-reverting process (the Ornstein-Uhlenbeck process), whereas Poterba and Summers (1987) propose the sum of a random walk and a stationary mean-reverting
process. Although neither study offers any theoretical justification for its proposal, both studies motivate their alternatives as models of investors’ fads."
This was also interesting and provides some reconciliation between long term mean version and the momentum effect:
Of course, the negative serial correlation in Fama and French’s (1987) study for long (three- to five-year) holding-period returns is, on purely theoretical grounds, not necessarily inconsistent with positive serial correlation for shorter holding-period returns.
The paper which I am quoting from actually found evidence in the other direction for whatever that is worth. I just skimmed the paper, but it seems there result where for weekly returns, whereas effect relevant to the OP is for longer term returns. Does this mean we should only rebalanced in long term to try to capture the short term positive serial correlation? I don't know?


Technical Note:
There is some difference between the Ornstein-Uhlenbeck process, and the the sum of a random walk and a stationary mean-reverting process. To me it seems like the differences in all of the utility functions, it matters sometimes for the mathatmetics, but intuitively they describe similar things (this very well may be wrong, and someone who has a better depth of Stochastic Process understanding, any corrections are appreciated.
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Post by Rick Ferri »

Avo wrote:
Rick Ferri wrote: This semi-active strategy reduces portfolio risk and increases returns in the long-term.
"Increases returns" compared to what, exactly??
To a portfolio allocated at the beginning of a period and not rebalanced.
If you mean "increases returns on a risk-adjusted basis", then you should say so. IMO, this is very different than "increases returns".
It does both. Over the past 40 years, a rebalanced portfolio of 40% US stocks, 20% international stocks, and 20% US Treasury notes outperformed a never rebalanced portfolio on a nominal AND risk adjusted basis. The same occurred over two independent 20-year periods. Breaking it down by decades, there was only one decade when the never rebalanced portfolio outperformed nominally (1991-2000) although it underperformed on a risk adjusted basis.

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Post by Lbill »

I've noticed that whenever portfolio rebalancing is discussed, there is never any mention of whether this is a risk-efficient strategy. In fact, it is not. The following chart represents the results from different rebalancing methods based on 10,000 Monte Carlo simulations using 7 different asset classes:

Image
Source: Phil Demuth
The first thing that stands out is that the more frequently we rebalance, the worse our returns. The next obvious point is that, as is commonly observed, rebalancing cuts our risks. What we’d hasten to add, however, is that it doesn’t cut our risks efficiently. Specifically, the most frequently recommended ritual—annual rebalancing—puts our portfolio’s returns-to-risk profile below the efficient frontier.

Tolerance-based approaches, on the other hand, seem to have more merit: Those portfolios that were allowed some leeway to roam before being rebalanced had better risk-adjusted returns (above the line) than those adjusted according to the calendar (below the line).
What's being ignored in discussions of rebalancing is that tolerance-based rebalancing strategies, while improving portfolio returns, do so by allowing portfolio risk levels to increase (which is contrary to the premise that the purpose of rebalancing is to maintain targeted risk levels). More frequent rebalancing; e.g., monthly, semi-annual, annual) do meet the objective of managing portfolio risk, but at the cost of reduced portfolio efficiency. Thus, it's hard to see just where the "free lunch" from portfolio rebalancing is being served.
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Post by bobcat2 »

Rick Ferri writes.
Over the past 40 years, a rebalanced portfolio of 40% US stocks, 20% international stocks, and 20% US Treasury notes outperformed a never rebalanced portfolio on a nominal AND risk adjusted basis.
What happened to the other 20%? :roll:

Rick also writes.
I have data going back 80 years.
So why are you only using half of your data?

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Post by fcirullo »

Rick Ferri wrote:So, what do you suggest we call this? A rebalancing benefit? A risk control benefit? A regression to the mean benefit? I don't know. The fact is, it happens. The returns are higher and the risks are lower than a buy, hold, and do nothing portfolio, i.e. the market. It needs to be called something smart and acedemic sounding. A "free lunch" doesn't cut it.

Rick Ferri
It may not be academic sounding, but calling it a rebalancing benefit works. When speaking with 401(k) or 403(b) participants, I would compare the strategy like this:
Long term performance:
Bad - Active fund strategies and market timing strategies.
Better - Buy, hold, and never rebalance using low-cost index funds.
Best - Buy, hold, and rebalance using low-cost index funds.
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Post by radionightster »

nisiprius wrote:Do we or do we not get a "rebalancing benefit" when we invest in a mutual fund that rebalances automatically, such as

Vanguard Balanced Index Fund (VBINX)
or the Vanguard Target Retirement funds

I realize that these invest in a smaller and tamer variety of asset classes than a typical "slice and dice" portfolio and therefore one might expect the benefit to be smaller; but is it there or not, and, if not, why not?
Mr. Ferri,

As always, thank you for sharing this with us. It's always a pleasure to read your posts and we are blessed to have you as a member of this community.

I am interested if you have an answer to Nisipirus's question. I too am curious if we get the rebalancing benefit from a target retirement fund.

I don't understand exactly what happens when a TR fund goes from, lets imagine, 70/20/10 to 60/20/20. Does it just reallocate your money, or does it actually do the same thing as rebalancing?

Thank you sir,
RN
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Post by Rick Ferri »

bobcat2 wrote:Rick Ferri writes.
Over the past 40 years, a rebalanced portfolio of 40% US stocks, 20% international stocks, and 20% US Treasury notes outperformed a never rebalanced portfolio on a nominal AND risk adjusted basis.
What happened to the other 20%? :roll:

Rick also writes.
I have data going back 80 years.
So why are you only using half of your data?

BobK
Whoops. I meant 40% bonds.

The international index only goes back to 1970. My 80 year data set is just US equity and fixed income. The results for rebalancing are positive in most decades, meaning there is at least a risk-adjusted return advantage.
radionightster wrote:
nisiprius wrote:Do we or do we not get a "rebalancing benefit" when we invest in a mutual fund that rebalances automatically, such as

Vanguard Balanced Index Fund (VBINX)
or the Vanguard Target Retirement funds

I realize that these invest in a smaller and tamer variety of asset classes than a typical "slice and dice" portfolio and therefore one might expect the benefit to be smaller; but is it there or not, and, if not, why not?
Mr. Ferri,

As always, thank you for sharing this with us. It's always a pleasure to read your posts and we are blessed to have you as a member of this community.

I am interested if you have an answer to Nisipirus's question. I too am curious if we get the rebalancing benefit from a target retirement fund.

I don't understand exactly what happens when a TR fund goes from, lets imagine, 70/20/10 to 60/20/20. Does it just reallocate your money, or does it actually do the same thing as rebalancing?

Thank you sir,
RN
I'm no expert on target date retirement funds. I assumption is that a long-dated fund (40 year) would have a rebalancing benefit initially because the asset allocation doesn't change very much from decade to decade. However, a short-term fund might have a negative outcome if the market has gone down and the glide-path takes the fund out of stocks before a recovery. For example, if a target date 2010 fund had investors 30% in stocks going into 2007, the took investors out of stocks gradually as the market fell though 2009. Again, I'm no expert on target date retirement funds.

Lbill,

The regression line in Phil DeMuth's chart looked very strange to me. After reading the article, I realized that "of course the no-rebalanced had a higher return over 25 years...because it had significantly higher risk!." Rebalancing takes some out of the riskier assets that are expected to go up more than the lower risk asset classes, and this lowers the long-term return of a portfolio during a strong bull market for risky assets.

So, what was the point of the article? I haven't figured that out yet. I guess the message is if you expect a strong bull market in stocks - don't rebalance.

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Post by radionightster »

Thank you Mr. Ferri.
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Post by baw703916 »

Lbill wrote:I've noticed that whenever portfolio rebalancing is discussed, there is never any mention of whether this is a risk-efficient strategy. In fact, it is not. The following chart represents the results from different rebalancing methods based on 10,000 Monte Carlo simulations using 7 different asset classes:

Image
Source: Phil Demuth
The first thing that stands out is that the more frequently we rebalance, the worse our returns. The next obvious point is that, as is commonly observed, rebalancing cuts our risks. What we’d hasten to add, however, is that it doesn’t cut our risks efficiently. Specifically, the most frequently recommended ritual—annual rebalancing—puts our portfolio’s returns-to-risk profile below the efficient frontier.

Tolerance-based approaches, on the other hand, seem to have more merit: Those portfolios that were allowed some leeway to roam before being rebalanced had better risk-adjusted returns (above the line) than those adjusted according to the calendar (below the line).
What's being ignored in discussions of rebalancing is that tolerance-based rebalancing strategies, while improving portfolio returns, do so by allowing portfolio risk levels to increase (which is contrary to the premise that the purpose of rebalancing is to maintain targeted risk levels). More frequent rebalancing; e.g., monthly, semi-annual, annual) do meet the objective of managing portfolio risk, but at the cost of reduced portfolio efficiency. Thus, it's hard to see just where the "free lunch" from portfolio rebalancing is being served.
How exactly was the Monte Carlo set up? Does it assume true random walk behavior (each result from the random number generator is independent)? I can't tell from the link.

In a random walk world, there is no rebalancing bonus (although rebalancing is likely to be useful for risk management). But the real world isn't quite a random walk. There's short-term momentum and longer term mean reversion. In such a case, rebalancing can give a better risk-adjusted return.
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Post by Lbill »

Rick -

As I recall, DeMuth concluded that fairly frequent re-balancing, in particular the commonly used calendar-based approach (e.g. annual rebalancing) serves the purpose of maintaining a fairly constant level of portfolio risk, but is actually not useful for boosting nominal or risk-adjusted returns - so he doesn't recommend it. This would seem to be at odds with your findings, though I do see a wide range of opinion in this regard. I believe that Larry, for one, has also agreed that calendar rebalancing will probably lower portfolio returns somewhat. Bill Bernstein also thinks that calendar rebalancing, if done too often, will probably accomplish little in terms of improving returns, so he suggests doing it every few years and not annually.

Using bands does improve not only returns but also risk-adjusted returns, and wider bands, such as 20%, work better than narrower bands in this regard. Of course, the reason bands work better is that they accommodate positive stock market momentum. So, DeMuth recommends using fairly wide bands such as 20%, while acknowledging that this method allows significant upward drift in portfolio risk. This, he says, is optimal in terms of risk-adjusted returns. The limiting case is, of course, to never rebalance, which produces the highest long-term portfolio returns with the highest risk. Of course "long-term" might be a really long term before this outcome is realized.
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Post by fundtalker123 »

Rick Ferri wrote:
pauliec84 wrote:Your claim that re-balancing within your risky asset allocations will increase risk/return profile may be right. But it is not MPT that makes this claim. It would be some sort of behavioral story. Your strategy is a departure from MPT.
I agree with you. So, what do you suggest we call this? A rebalancing benefit? A risk control benefit? A regression to the mean benefit? I don't know. The fact is, it happens. The returns are higher and the risks are lower than a buy, hold, and do nothing portfolio, i.e. the market. It needs to be called something smart and acedemic sounding. A "free lunch" doesn't cut it.

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Re: Picking winning fund managers ?

Post by muddyglass »

The very reason budding academics such as William Sharpe, Eugene Fama, Michael Jensen, and Jack Treynor studied mutual fund returns in the 1960s was in an effort to discover managers who beat the markets and immolate their methods. Their efforts were largely unsuccessful back then, and new efforts by other academics since the 1960s have remained unsuccessful.

If the brightest Ph.D.s can’t figure out how to pick a winning manager, then it’s not likely that an individual investor or investment advisor is going to do it.
rick, i believe you meant to use the word "emulate" in that passage, not "immolate."

(on a side note, i recently read and enjoyed your book "all about asset allocation." keep up the good work.)
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Post by Rick Ferri »

Thanks, it's being fixed.
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Post by Rick Ferri »

Lbill wrote:Rick -

As I recall, DeMuth concluded that fairly frequent re-balancing, in particular the commonly used calendar-based approach (e.g. annual rebalancing) serves the purpose of maintaining a fairly constant level of portfolio risk, but is actually not useful for boosting nominal or risk-adjusted returns...This would seem to be at odds with your findings....Using bands does improve not only returns but also risk-adjusted returns, and wider bands, such as 20%, work better than narrower bands in this regard. Of course, the reason bands work better is that they accommodate positive stock market momentum.
I concur with DeMuth's findings (and dozens of similar studies) that there is a definite difference in rebalancing annually, rebalancing by bands, and not rebalancing. My studies have shown that the band method has produced somewhat higher returns and risk adjusted returns over the annual method (which is the reason I've been using bands for 12 years.)

There is also a trade-off between risk and return. The more rebalancing that's done, the lower the risk and the lower the return. Using a 60/40 portfolio, annual rebalancing would have meant 12 rebalancing events over the past 12 years. A 10% band generated 7 rebalancings events. A 20% band generated only 2 rebalancing events. If dividends and interest go to cash, and that cash is reinvested in the low asset class, there would have been 5 rebalancing events using 10% bands and NO rebalancing events using a 20% bands over the past 12 years.

As all rebalancing studies concludes, fewer rebalancing events generated higher returns, although at a higher risk. This is where a risk-adjusted return calculation comes in handy. I used a Sharpe ratio (Return less T-bills divided by standard deviation). In time periods, the 10% band generated better risk adjusted returns than annual rebalancing and no rebalancing. A 20% band had a Sharpe ratio that was close to a 10% band.

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Post by pauliec84 »

In a random walk world, there is no rebalancing bonus (although rebalancing is likely to be useful for risk management). But the real world isn't quite a random walk. There's short-term momentum and longer term mean reversion. In such a case, rebalancing can give a better risk-adjusted return.
+1.

Without some long term mean reversion in the random number generation a monte carlo doesn't tell es anything. So we can throw DeMuth's findings out the window.

Rick. You haven't addressed how you are going to deal with trading costs/tax implication. For the everyday investor these can be significant.
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Post by Rick Ferri »

pauliec84 wrote:Rick. You haven't addressed how you are going to deal with trading costs/tax implication. For the everyday investor these can be significant.
I don't recommend rebalancing every single position every year. Only rebalance those that are out of parameters by a large enough amount to make a difference. In addition, Vanguard open-end funds are free to trade, as well as their ETFs. It's useful to use as many commission-free funds as is feasible.

Rebalancing is only one part of portfolio management. There is also cash management, i.e. were divided, interest, and new cash is invested, and in a taxable account, tax-loss harvesting. I let cash dividends and interest flow into a money market fund and then allocate that cash were needed. This cuts down on the number of rebalancing events (5 versus 7 over 12 years). Rebalancing is also done conjunction with tax-loss harvesting. If there are loses in a portfolio, swap out of the losing position into a comparable fund and use the loss to offset gains from selling.

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Post by pauliec84 »

I don't recommend rebalancing every single position every year. Only rebalance those that are out of parameters by a large enough amount to make a difference. In addition, Vanguard open-end funds are free to trade, as well as their ETFs. It's useful to use as many commission-free funds as is feasible.

Rebalancing is only one part of portfolio management. There is also cash management, i.e. were divided, interest, and new cash is invested, and in a taxable account, tax-loss harvesting. I let cash dividends and interest flow into a money market fund and then allocate that cash were needed. This cuts down on the number of rebalancing events (5 versus 7 over 12 years). Rebalancing is also done conjunction with tax-loss harvesting. If there are loses in a portfolio, swap out of the losing position into a comparable fund and use the loss to offset gains from selling.
I understand this. But by definition when you rebalance you sell winners and buy losers. So you are going to incur tax losses.

My point is when you do your portfolio per the OP, if you do not account for the additional tax losses and the transactions costs, it will be a unfair comparison to the buy and hold portfolio.
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Post by Lbill »

pauliec84 wrote:
Without some long term mean reversion in the random number generation a monte carlo doesn't tell es anything. So we can throw DeMuth's findings out the window
I don't recall the methodology used by DeMuth, but some of his findings are essentially confirmed in a nice analysis by Vanguard, which also employed Monte Carlo simulations under different market scenarios: trending, mean-reversion, and random walk.

Trending:
If equity prices rise every period, regular rebalancing implies continually selling the strongly performing asset and investing in the weaker performer. The result is a lower return compared with a less frequently rebalanced portfolio
Mean-Reverting:
Although a portfolio’s buy-and-sell decisions are generally well timed when rebalancing in a mean reverting market, our simulation indicated that as a portfolio was rebalanced more frequently, or within tighter bands, its absolute average return decreased.
https://institutional.vanguard.com/iip/ ... ancing.pdf

Based on these results and Rick's comments, it seems to me that rebalancing using bands, which results in less frequent rebalancing events, should be expected to result in somewhat better risk-adjusted returns if one is indifferent to the degree of drift in portfolio risk (volatility) that can occur using this method. Of course this will also depend on the exact asset mix that is being held, correlations between assets, expected asset returns and volatilities, etc.
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Post by Random Musings »

One must also consider rebalancing events as a result of risk needs in a portfolio.

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Post by Bob Sawyer »

We calculated the benefit of rebalancing at .55% per year, for what it is worth.

One problem with rebalancing is it is not that easy to do if you have multiple accounts. We wrote a tool to do it. See http://openindexinvestors.com/portfoliobuilder.htm

Features include:

- Support for two accounts (one taxable and one IRA, usually) plus outside holdings (the rebalancer performs optimal asset location).
- You can import your holdings from Schwab, Fidelity or Vanguard.
- For advanced users, there are lots of configuration options.
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Post by Bob Sawyer »

nisiprius wrote:Do we or do we not get a "rebalancing benefit" when we invest in a mutual fund that rebalances automatically, such as

Vanguard Balanced Index Fund (VBINX)
or the Vanguard Target Retirement funds

I realize that these invest in a smaller and tamer variety of asset classes than a typical "slice and dice" portfolio and therefore one might expect the benefit to be smaller; but is it there or not, and, if not, why not?
A similar question came up in another forum, specifically around VSCGX. Presumably you do inherit some benefit from the rebalancing done by the fund, although it begs the question what approach they are taking (tolerance bands, rebalance at regular intervals, etc). I also wonder if (warning: cynical comment follows) in-house balanced funds are used by the underlying funds to lessen their cash drag - ie, if a lot of money is being pulled out of an underlying fund, they ask VSCGX to temporarily increase its holdings of that fund, so they don't have to sell any stocks.

Be that as it may, I had four other comments in that forum:

(1) In the case of VSCGX I calculated that once your investment reached $250k, you could cut your expense ratio to .13% versus .24% by investing directly in Admiral versions of the underlying funds.

(2) A balanced fund precludes optimal asset location (ie placing tax inefficient asset classes in an IRA).

(3) A balanced fund doesn't allow you to do tax loss harvesting of the underlying funds.

(4) When you own the underlying funds in a mixture of taxable and tax-deferred accounts, you can do rebalancing in a more tax efficient fashion.
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Post by baw703916 »

Lbill wrote:pauliec84 wrote:
Without some long term mean reversion in the random number generation a monte carlo doesn't tell es anything. So we can throw DeMuth's findings out the window
I don't recall the methodology used by DeMuth, but some of his findings are essentially confirmed in a nice analysis by Vanguard, which also employed Monte Carlo simulations under different market scenarios: trending, mean-reversion, and random walk.

Trending:
If equity prices rise every period, regular rebalancing implies continually selling the strongly performing asset and investing in the weaker performer. The result is a lower return compared with a less frequently rebalanced portfolio
Mean-Reverting:
Although a portfolio’s buy-and-sell decisions are generally well timed when rebalancing in a mean reverting market, our simulation indicated that as a portfolio was rebalanced more frequently, or within tighter bands, its absolute average return decreased.
https://institutional.vanguard.com/iip/ ... ancing.pdf

Based on these results and Rick's comments, it seems to me that rebalancing using bands, which results in less frequent rebalancing events, should be expected to result in somewhat better risk-adjusted returns if one is indifferent to the degree of drift in portfolio risk (volatility) that can occur using this method. Of course this will also depend on the exact asset mix that is being held, correlations between assets, expected asset returns and volatilities, etc.
Thanks for posting the Vanguard document.

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Post by rustymutt »

I have a problem with this report. No support details are given. Which active funds lost out to which index funds, and what market. Those are very important points Rick. It may well be the case, but when you report this, don't we have the right to see the underlying thesis facts? This is how the market timers make up their reports. Where is the evidence, and facts?
Rick, your beginning to appear more like a salesman than a adviser.
Last edited by rustymutt on Fri Mar 18, 2011 10:47 am, edited 1 time in total.
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Post by Avo »

Lbill wrote:Image
This chart makes perfect sense. Rick's claim does not make sense: over time, rebalancing should lose to keeping an every higher percentage of funds in the fastest growing asset class.
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Post by Avo »

rustymutt wrote:I have a problem with this report. No support details are given. Which active funds lost out to which index funds, and what market. Those are very important points Rick. It may well be the case, but when you report this, don't we have the right to see the underlying thesis facts? This is how the market timers make up their reports. Where is the evidence, and facts?
+1. It doesn't help that Rick's posts are often typo ridden. (I corrected one such typo above.) This lack of attention to detail in what he posts makes me question his attention to detail in the underlying analysis, especially when it comes to a conclusion that makes no sense on a fundamental level.
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Post by nisiprius »

baw703916 wrote:But the real world isn't quite a random walk. There's short-term momentum and longer term mean reversion. In such a case, rebalancing can give a better risk-adjusted return.
When were "short-term momentum and longer term mean reversion" discovered? I'm thinking it was a while ago, because mean reversion was definitely mentioned in the 3rd edition of Stocks for the Long Run, and not as a new thing; I think Siegel was one of the researchers involved.

So if these effects were discovered over a decade ago, why hasn't the market priced them in yet? Do we think there is a persistent and predictable behavioral irrationality that cannot be eradicated even when it is understood?

Why shouldn't I think the "rebalancing benefit" might be just another "Dogs of the Dow?"
Last edited by nisiprius on Thu Mar 17, 2011 5:54 pm, edited 1 time in total.
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Post by pauliec84 »

Instead of that graph how about the sharp ratios of each strategy?

Never Rebalance: 11% Return, 10% SD.
Annual Rebalance: 9% Return, ~6.6% SD.

The Annual Rebalanced wins out per risk adjusted return.

I agree that Rick has not produced a coherent argument of why re balancing makes sense. He also declined to comment on his complete avoidance of tax considerations which favor buy and hold.

I will try to defend the re-balancing on his behalf (not saying this is definitely true but is an argument that one could make).

-An mean-variance optimizing investor picks a certain asset allocation he feels maximizes his sharp ratio.

-As an individual investors allocations drift from his assigned level, his portoflio moves away from optimized sharp ratio.

- To rearrive back at optimal sharp ratio portfolio investor must rebalanced portfolio.

You cannot ignore risk. Of course a portfolio of just 1 asset, the highest returning asset will have the highest return in the as time approaches infinity.
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