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.

Comments & Questions

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3 Replies to “Improving Portfolio Re-balancing”

  1. A few days ago I was reading an interesting article about rebalancing on Newfound Research ( for reference: “Questioning Your Most Dangerous Assumptions: Does Rebalancing Add Value?”)

    Your article Daren, like the one above, exposes the drawbacks of rebalancing in an uptrend market. Your article nontheless is more concrete as you laid down rules to rebalance. In the Newfound article they just compared a non-rebalanced portfolio vs one that is rebalanced.

    Could you suggest any other literture about this topic? Thanks.

  2. Daren (Editor) says:

    I just read the article at Newfound and I think he is making a slightly different point about re-balancing, although the skepticism of blind annual re-balancing is the same. I discovered Newfound a few months back with the Dual Momentum article they posted. Interestingly, looking back on their posts I see a fair amount of overlap between Corey’s thought process and mine. He does a much better job of mapping ideas out mathematically and articulating the ideas than I do, so there’s a lot I can learn from him.
    I believe the idea of not adding to losing positions in a downtrend goes back a long time. It’s really Ricardo and Livermore stuff, with more ideas building from there. I would recommend reading Jesse Livermore books if you haven’t already. Also, the white papers from the trend following houses are pretty good: AQR, Man-AHL, and Capital Fund Management come to mind. In fact, I think AHL did a whitepaper on the re-balancing topic recently. Not to take anything away from these publications because they can propel ideas forward, but I think it’s important to recognize the ideas behind many of these whitepapers are not new. The oft-cited Jegadeesh & Titman paper is a prime example of how enormous academic credit can be given to a new academic whitepaper for an idea that was in practice for decades (or even centuries) before 1993.

  3. Yanniel says:

    I appreciate your feedback Daren and the literature suggestions.

    I came across Newfound when you posted about their DM fragility’s article. Some of their articles have caught my eye, in particular the ones about portfolio rebalancing.

    When you posted about this topic I said to myself: “what a coincidence?!” (I was actually going to suggest a post about this topic).

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