End of the year, it’s time to rebalance

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Chart shows how rebalancing has fared (SOURCE: Bloomberg, iFAST compilations as at December 24, 2012)

WE have a long running back test which we have been maintaining for nearly nine years now. This involves the concept of rebalancing. The rebalancing method has shown that over a long period of time (our back test is over twenty-four years), a portfolio that used the rebalancing method has outperformed passive buy-and-hold methods by a quite a large margin. We have updated the numbers for 2012 year-to-date, and the backtested rebalanced portfolio has continued to outperform.

Firstly, just a brief recap on the details of rebalancing and the portfolio we used to test rebalancing through the years. Rebalancing involves setting a fixed portfolio allocation from the very start.  So, for example, you set an allocation of 30 per cent into US equities, 30 per cent into Asia Pacific ex-Japan equities, 30 per cent into Europe equities, and 10 per cent into Japan equities. Then, at the end of a fixed period like a year, markets would have moved differently.

So, you then buy or sell which ever portions needed until you have the same exact allocation again. And this exercise continues faithfully each year for as long as the portfolio is in operation.

Basically, what this forces you to do is to take profit from your best performing sectors/regions, and to invest more into the underperforming regions/sectors that year. It is a mechanical method that disregards what you think of markets.  It works on the principle that no single market will ever be best performing all the time through the years, and neither will any single market ever stay down in the dumps every single year.

So, as the market cycles go through their rise and falls, the method will eventually result in you buying more of a market when that market is low, and selling some of a market that has gone up sharply.  Thus, it ultimately results in an investor buying low and selling high, which is the recipe for a successful portfolio. We will now go over how we actually implemented this into our back tested portfolio over the last twenty four years and how it has fared. Our portfolio is made up of seven markets represented by their respective benchmark indices. These were allocated based on the following allocation.

Now that we have explained the concept, we look at 2012 (with a few more days until the start of 2013) and see how this method would have fared. We used an all equity portfolio split along geographical lines – the US, Europe, Japan, and the four Asia tigers (Singapore, Taiwan, Hong Kong and Korea). We used the indices S&P 500, Stoxx Europe 600 Price, Nikkei 225, Hang Seng, FTSE Straits Times, TWSE and KOSPI indices as proxies for the performance of these markets over the time period.

Our initial allocation was 30 per cent US, 30 per cent Europe, 10 per cent Japan, 7.5 per cent South Korea, 7.5 per cent Hong Kong, 7.5 per cent Singapore and 7.5 per cent Taiwan. We then started rebalancing it all the way from the beginning of 1989 to December 24, 2012 and at the end of every year over the past twenty-four years, we sell the leaders and buy into the laggards, bringing the portfolio back to the initial allocation. From an initial portfolio of RM10,000 at the start of 1989, the chart above shows the growth of the portfolio based on rebalancing and compared to a world equities portfolio as represented by the MSCI AC World index. As you can see, after 24 years, the portfolio managed using the rebalancing method had grown to RM74,167.

In comparison, a RM10,000 portfolio composed of the MSCI AC World index would have grown to just RM42,133, while a non-rebalanced portfolio would have grown to RM71,241. The difference is significant; annual rebalancing has generated superior return vis-à-vis a passive index strategy and also the buy-and-hold strategy.

Adjusted for dividends re-invested and in RM terms

Zooming down into 2012, how did rebalancing affect the portfolio? The buy-and-hold portfolio gained 16.7 per cent year-to-date (as of December 24, 2012), 1.5 per cent points more than the 15.2 per cent gain observed for the rebalanced portfolio.

Both portfolios outperformed the MSCI AC World Index, which only gained 12.9 per cent as the index has higher concentration in developed market equities, which have done well in 2012 but still underperformed riskier Asia Pacific ex-Japan markets.

Summing it up

In 2007, the Asian markets were far and away the best performers amongst the seven markets, and the worst performers were Japan and US. Rebalancing forced us to take profit from Asian markets and add to the US and Japan.

In 2008, these two markets on a relative basis (especially Japan) dropped less than the Asian markets, which meant that when the year was over, rebalancing then forced us to take money from US and Japan and add it back into the four Asian markets again. And in 2009, true to form, the four Asian markets all vastly outperformed US and Japan.

In conclusion, the rebalancing method has outperformed the MSCI AC World index in 2012 but underperformed the buy-and-hold strategy year-to-date (as of December 24, 2012).  While it is not expected to outperform this index nor the buy-and-hold strategy every single year, it has managed to do so frequently enough over a long period of time such that the improvement in a portfolio’s gain is quite significant.

At the end of the twenty-four year period, the difference between the rebalanced portfolio and buy-and-hold portfolio is RM2,926. That is why as we come to the end of the year, investors who are reviewing their portfolio might wish to consider rebalancing if they want a disciplined method that works over the long term.