Improving Portfolio Re-balancing

Several weeks ago I shared a post on the clear risk superiority of Leveraged Barbell Portfolios when compared to a standard 60/40 index portfolio. In my example, with a tiny 12.5 percent allocation to a 3x leveraged ETF and the rest of your portfolio in bonds, you could have matched the returns of a 60/40 portfolio over the past seven decades.

Your drawdowns would have been much smaller and your returns much smoother than a traditional 60/40 portfolio. Effectively, a Leveraged Barbell Portfolio can provide outstanding risk-adjusted and gross returns.

You can read the details in this post: Risk Mitigation with a Barbell Portfolio.

My example used simple annual re-balancing without any added strategies to further control risk. As my post shows, regular periodic re-balancing works pretty good. If you want to have a low maintenance portfolio that shows great historical returns, you can do well re-balancing your positions to target once per year, or even once every six months or quarter.

One of the downsides of periodic re-balancing is the effect of compounding losses in multi-period market drawdowns. Regularly pulling capital away from bonds and placing it into declining stocks can become very costly. If we avoid re-balancing in downtrending markets, we can reduce overall portfolio drawdowns and increase performance.

There are some relatively simple strategies we can use to improve results. Basic indicators identifying trends can help avoid pulling money away from bonds in a downtrending market.  At the same time, these indicators can help us stay in uptrending markets for as long as possible in attempt to capture the compounded gains on our equity positions.

In all of the following examples in this post we will target the following portfolio allocation on re-balancing: 15 percent 3x daily leveraged S&P 500 and 85 percent U.S. T-bill returns (no fees or taxes).

Avoid Re-balancing Into a Downtrend

There are many ways to measure trends; the pros and cons of various tools are extensively debated. One of the most popular, tried and true methods is the simple moving average (SMA).

In this first demonstration, we will use the 12-month SMA to identify long-term trends. Our goal is to focus on long-term trends to avoid re-balancing in extended drawdowns or lose on potential gains by re-balancing in small market corrections.

Here are the re-balancing rules for this first test:

  • If the monthly close of the S&P 500 is above the 12-month SMA, we will re-balance the portfolio every twelve months.
  • If the monthly close of the S&P 500 is below the 12-month SMA, we will re-balance to take risk off (if needed) and then not re-balance again until the monthly close is back above the 12-month SMA.
  • We will only re-balance if the allocation is reset in the favour of the trend. For example, we will not re-balance if the trend turns up by adding to the bond position. Likewise, we will not re-balance if the trend turns down by adding to the leveraged equity position.

Our example will compare returns of this rule-based method with the baseline annual re-balancing method. For the baseline portfolio, the re-balancing is done at the end of each calendar year.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

The returns of each method overall are nearly the same. Both show a compounded annual return in the range of 9.75 percent.

The following chart shows the drawdowns for each method over the same time period.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

As the chart shows, the largest drawdown periods since 1950 are much lower when the 12-month SMA trend filter is added. Remember, in uptrends both portfolios are still re-balanced every year.

The 12-month SMA filter doesn't have a significant affect on the small drawdowns that occur over this backtest period. The timing, frequency, intensity, and duration of small drawdowns are nearly identical across both strategies. The small variations that do occur are primarily due to the differences in the re-balancing at the end of the calendar year (annual re-balancing) vs. 12-month intervals (12-month SMA filter).

Responsive Trend Re-balancing

In this next example, we will re-balance following trend signals only. This test will be a demonstration of the sensitivity of shorter signals in downtrends as well as the importance of staying in uptrending markets for as long as possible.

To manage risk in this scenario, we will follow a shorter term trend measurement—the 13-week SMA (one-quarter of the full year).

Here are the re-balancing rules for this test:

  • If the weekly close moves above the 13-week SMA, we will re-balance in the favour of equities.
  • If the weekly close moves below the 13-week SMA, we will re-balance in the favour of bonds.
  • Re-balancing will only be done when a new signal change is shown. We will not re-balance in the middle of a uptrend or downtrend.

The following charts will compare this 13-week SMA method with the 12-month SMA where we re-balanced annually in uptrends (the method used above).

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

Staying in trends for as long as possible is very important and can lead to outsized returns thanks to the effects of compounding returns with leverage. The 13-week SMA method achieved a 10.6 percent compound annual growth rate over the past seven decades.

We can see a consistent pattern on meaningful performance gains across time periods using the 13-week SMA method as shown when looking at the 3-year rolling returns. Most of the excess gains come during uptrending market periods.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

However, as the rolling return chart above shows, the drawdowns of shorter trend signals compared with longer trend signals demonstrates a noticeably different pattern. The following drawdown chart clarifies this.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

While the largest drawdowns in the 12-month system capped out at approximately 14 percent, the shorter 13-week signal put us back into the market several times during a long-term downtrend leading to larger compounding losses. We see this with the larger drawdown periods in 1973-1974, 2000-2003, and 2007-2009 periods.

That said, the losses are still very tolerable at just under 18 percent in the worst case. Notably, the shorter signal had us in fewer drawdown periods otherwise. Since the shorter signal re-balanced into leveraged equities faster as new uptrends started, the drawdowns were also typically shorter in duration for the 13-week SMA method.

Summary

There are many ways to improve on a basic re-balancing technique and this article just scratches the surface of the various methods available. Our chosen preference also depends on which particular forms of risk we are trying to reduce. For example, we can focus our re-balancing on trying to reduce capital at risk, we can try reduce the severity of drawdowns, we can try reduce overall time in drawdown, or we can try stay in uptrends as long as possible.

Portfolio management and risk management is complex with many variables. We can use tools to shift risks where it best suits our needs, but we can never eliminate risk without sacrificing total returns.

I used a Leveraged Barbell Portfolio to demonstrate various re-balancing methods; these basic principles for thoughtful re-balancing could be applied to traditional 60/40 portfolios as well.

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Bonds or Safe, Reliable Assets

In my posts about Leveraged Barbell Portfolios, I talk about bonds as being the primary holding for investors. Sometimes I mention the term "quality bonds". However, I think it is important to clarify what I precisely mean when discussing bonds in this context.

I tend to use bonds (or "quality bonds") as a proxy term for a safe, reliable asset. There are many opinions on what that means, but I think we can identify some characteristics of a safe, reliable asset.

  1. The asset is not likely to lose value in the short term. (Positive expected nominal returns).
  2. The asset is likely to maintain or increase its purchasing power over longer time periods. (Positive expected real returns).
  3. The asset is liquid. (Active marketplace, low transactions costs, easily divisible.)
  4. The asset is not likely to suffer from expropriation or cancellation (Legal forms of property loss.)
  5. The asset is not likely to be stolen or destroyed. (Illegal forms property loss.)
  6. The asset is durable. (Natural forms of property loss.)

There may be more identifiers of safe, reliable assets, but I think this is a pretty good list to start with.

Quality Bond Characteristics

By these metrics, we should consider the attributes of what I describe as "quality bonds". Quality bonds are high-rated shorter duration government bonds and certain high quality shorter duration corporate bonds.

They almost always have positive nominal returns. In any event, drawdowns in nominal terms are minimal and the coupon can be held until expiry where the face value is paid.

Quality bonds do not always have positive real returns, but they tend to be positive over time. Inflation risk and interest rate risk can be mitigated through building a portfolio of laddered shorter duration bonds. This means interest rates on individual coupons are constantly updated. Most shorter duration bond ETFs provide this service as part of their nature.

These bonds are highly liquid. With face values as low as $100 per coupon, it is easy to sell a small portion of overall bond holdings. In addition, transaction costs are tiny and the trading market is absolutely massive. ETFs can add obvious liquidity benefits for retail investors.

Bonds can suffer from expropriation or cancellation, particularly government bonds from higher risk countries and lower quality corporate bonds via bankruptcy. However, I think this risk can be alleviated quite easily with some basic screening techniques for issuer quality.

Bonds are very unlikely to be stolen or destroyed through criminality. Brokerage accounts, where these instruments are typically held, are insured. If your brokerage is in a country with a good track record for property rights, as most are, the risks are low.

Unlike physical assets that may be subject to deterioration, bonds do not have these properties. They are electronic, ownership is carefully recorded, and they don't physically erode.

Other Real Assets

Other assets that may be typically thought of as safe do not share as many of the same characteristics of safe, reliable assets as quality bonds do. Some of the other assets stated as being safe with stable value include physical gold and silver, productive land, real property improvements, live agricultural assets, and resource extraction rights.

Physical precious metals have a long history and extensive following as being the premier safe asset. In many ways I like precious metals. However, precious metals are not liquid and suffers from illegal property loss risk. The liquidity component may change if we ever move back to a gold standard, but a lot of things would have to change before that happens.

Productive land is in many ways a great asset. However, it is not liquid. There are also risks for durability and legal property loss, but these can be mitigated by choosing a country that respects property rights and a location that is less prone to natural disaster.

Real property improvements (buildings, etc.) are not liquid and not durable. Unlike productive land, buildings and other improvements must be constantly maintained. Eventually, many are simply replaced or removed as the maintenance becomes to burdensome or the characteristics of the area change. Like land, selling real property improvements can be expensive with lots of time and paperwork involved.

Live agriculture assets are interesting. Forests, perennial crops, cattle herds, and farmed or ranched fisheries have many characteristics of safe, reliable assets. They tend to maintain their value over time in real terms and have many liquidity features. However, they can suffer from illegal property loss and may not always be durable (forest fires, disease, etc.). They also require tending and maintenance to ensure long-term value characteristics.

Resource extraction rights, such as mining rights, fishing rights, water rights, agriculture production rights, and so on are essentially legal assets. Though not always, the markets for these assets can be very limited and I believe they carry significant risks. They can suffer from legal property right concerns as they are often politicized due to their monopolistic nature. However, they are often durable and not likely to suffer form illegal property loss with some screening.

Bigger Picture Views

As I've stated on this blog many times before, I believe most investors should have a sizeable allocation to safe, reliable assets. The go-to asset in this context should be quality bonds. While not perfect, they are as close to a safe, reliable asset that an average investor can access on the market today.

However, as an investor's portfolio grows, there may be less reasons to only choose quality bonds as the safe, reliable asset. As the list of alternatives above shows, there are other assets that carry many positive characteristics and returns which are likely to be different from quality bonds, or those growth charging equities.

As well, risks and priorities begin to shift as a portfolio grows. It is reasonably safe to assume that investors will always look for their assets to have positive nominal and real returns over time, that they don't suffer from illegal or legal property loss, and that the asset exhibits some durability or compensate for loss.

The biggest difference may be in the form of liquidity needs. If you have a $500,000 portfolio with $400,000 in safe, reliable assets, it is essential these assets are liquid as you may need to tap into the portfolio and don't want to distort your risk profile too much.

However, if you have a $5 million portfolio with $4 million in safe, reliable assets things are different. The likelihood of needing more than a few hundred thousand for any purpose is very low. At this point, assets like productive land, physical precious metals, real property improvements, and agriculture assets may become very appealing as a component of the overall portfolio despite their lower liquidity characteristics and other management requirements.

As portfolios get even larger, additional risks may be taken on because they are less likely to cause large disruptions in total wealth in their lower probability, large impact risks. For example, resource extraction rights may enter the portfolio. There is the risk of total loss, but there is the advantage of steady, monopolistic investment returns on that asset for a long time.

When I discuss bonds or quality bonds as a core part of the portfolio, it should always be taken in a wider context of the investor's situation. I am generally referring to safe, reliable assets that are suitable for the investor.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.