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Portfolio rebalancing is perhaps the only 'free' lunch once you have set a strategic portfolio allocation based on your risk profile. Numerous articles have been published to study the pros and cons of portfolio rebalancing. The key factors behind portfolio rebalancing are:

• Risk and return control: when certain assets have appreciated too much, you would like to "take some money off the table" by selling portions of assets to bring back to your preset allocation targets. When certain assets have gone down too much, you would like to "buy cheap" so that you could take the "on sale" opportunity.
• Psychological feeling: when your portfolio allocation is out of balance, the over weight or under weight will give you uneasy feeling. Such a feeling is best described as the urge to do something in behavioral finance. Investors so often want to do something about their investment and most of time, they venture into markets without a clear guideline on their portfolio allocation. By the time they realize, their portfolio is out of whack and very often, they also lose money. Portfolio rebalancing with target allocations fixed is a sensible safe guideline to curb such "random" behavior.

As stock and other assets have appreciated so much recently (see the following table), the uneasy feeling on a looming correction is on everyone's mind. Now that we are approaching the end of third quarter,  it is time to have a checkup on your portfolios. 

Description	Symbol	1 Week	4 Weeks	13 Weeks	26 Weeks	52 Weeks
US Equity REITs	VNQ	-5.38%	3.39%	33.72%	71.82%	-29.51%
International REITs	RWX	-3.54%	3.64%	22.04%	58.26%	-11.72%
Emerging Market Stks	VWO	-1.94%	6.28%	18.57%	56.09%	10.61%
International Developed Stks	EFA	-2.43%	2.22%	18.04%	45.45%	-6.10%
Frontier Market Stks	FRN	-1.31%	5.61%	17.89%	60.39%	-5.25%
US Stocks	VTI	-2.40%	1.79%	15.16%	30.68%	-11.42%
US High Yield Bonds	JNK	0.84%	5.94%	13.83%	38.80%	10.95%
Emerging Mkt Bonds	PCY	0.04%	3.72%	13.43%	26.74%	22.77%
International Treasury Bonds	BWX	0.05%	2.95%	6.49%	13.47%	10.91%
Municipal Bonds	MUB	0.47%	2.58%	5.93%	7.20%	10.80%
US Credit Bonds	CFT	1.06%	1.62%	5.54%	15.49%	16.50%
Gold	GLD	-1.69%	3.33%	5.10%	6.96%	11.96%
Total US Bonds	BND	0.46%	0.81%	2.29%	4.33%	7.13%
Intermediate Treasuries	IEF	1.10%	0.93%	1.89%	-2.87%	6.96%
Mortgage Back Bonds	MBB	0.31%	0.62%	1.57%	2.06%	7.93%
Treasury Bills	SHV	-0.02%	-0.01%	-0.03%	0.07%	0.60%
Commodities	GSG	-2.24%	-5.34%	-2.92%	12.76%	-47.54%

The most popular rebalancing method is to periodically rebalance monthly, quarterly or annually rebalancing. For people who would like to be more active, opportunistic rebalancing strategy proposed by Gobind Daryanani from TD Ameritrade Institutional has shown to be effective if proper parameters are chosen. The opportunistic rebalancing method examines a portfolio periodically (such as biweekly). For those assets whose allocations are out of certain preset threshold (such as 20% more or less than the target percentage), these assets are rebalanced back to their target allocation percentages. For example, an asset with 30% target allocation would be rebalanced back to its 30% target if its allocation is over 36% or under 24%.  The following table compares the performances of three methods: no rebalancing, annual rebalancing, quarter rebalancing and opportunistic rebalancing (monthly check and 20% band) on a Roger Gibson Five Asset Portfolio.

Annualized  Return	Last 5 Years	Last 3 Years	Last 1 Year	Since 12/31/1997
Opportunistic Rebalancing Monthly 20% Band	3.39%	-3.35%	-15.67%	5.61%
Roger Gibson Annual Rebalancing	2.37%	-4.4%	-17.6%	5.41%
Roger Gibson Quarterly Rebalancing	3.09%	-3.7%	-16.15%	5.31%
Roger Gibson Monthly Rebalancing	2.35%	-4.65%	-17.84%	4.92%
Roger Gibson No Rebalancing	1.69%	-5.85%	-18.77%	4.17%

It should be noted that there are various parameters to be set for the opportunistic rebalancing method. Some of them are not as good as even a periodical rebalancing. However, rebalancing in some way definitely helps to improve your portfolio performance. Interested readers could further compare the risk (standard deviation and maximum drawdown) for these portfolios (and their various settings) from here.
It is also interesting to apply timing techniques to portfolio rebalancing.  In our previous article we showed that applying timing to a diversified portfolio could reduce risk and enhance return. Using this in a portfolio rebalancing manner deserves a separate serious study.

Labels: BWX, CFT, DBC, EEM, EFA, GLD, HYG, IWM, IWN, IYR, JNK, LQD, MDY, PCY, SHY, SPY, Strategy_340, TIP, TLT

With summer fading away, we now suddenly find ourselves in September, one of the worst months for the stock market. It is thus a good time to check up your portfolio and make necessary adjustments if it is necessary.

In the previous article, we introduced ValidFi's Guru Asset Allocation Watch and strategies. The Guru Asset Allocation Clone strategy applies ValidFi's proprietary algorithm to detect a mutual fund's asset exposure and utilizes the derived information to make necessary asset allocation decision for each month. The risk adjusted performance of the strategy is fairly impressive for the past ten years. Readers could examine one of its model portfolios for more information.

The portfolio recently made a noticeable asset allocation change on August 31st. 2009. The following table compares its August and September allocations (notice that the funds used to represent the asset classes could be replaced by ETFs such as SPY, EFA, IYR, TIP, CIU or CFT, BWX, EEM, HYG or JNK and BND or AGG).

Asset	August Allocation	September Allocation
VBMFX	0.00%	0.00%
VFISX	20.47%	0.00%
VWEHX	0.56%	2.31%
VEIEX	3.50%	5.08%
TGBAX	10.25%	0.00%
VFICX	15.09%	46.52%
VIPSX	10.80%	27.98%
VGSIX	0.03%	0.06%
GLD	0.00%	0.00%
VGTSX	2.96%	1.96%
VFINX	36.34%	16.08%
Stock Exposure	42.83%	23.18%

From the above table, the most noticeable changes are:

• Total stock exposure: reduced from 42.83% to 23.18%
• Fixed income allocation: big increase to Investment Grade Corporate Bond (VFICX) and Inflation Protected Treasury Bond (VIPSX)

The September allocation is very defensive.

Let us further examine the recent allocation moves for several top performing allocation funds.
The following picture illustrates Vanguard Wellesley Income Fund (VWINX). We could see the fund made noticeable reduction in equity exposure during August.



The other top allocation fund, GMO Benchmark-Free Allocation GBMFX has the following allocation trend:



Again, the fund made equity reduction during the August time frame.

Readers are encouraged to take advantage of the ValidFi's Real Time Asset Allocation tool to find out asset allocation trends of your favorite funds. It is free but requires a registration during its Beta testing period.
To summarize, several great asset allocation investors have made a very defensive move. Even if you don't want to change your asset allocation right now, it pays to keep an eye on this.

Labels: BWX, CFT, CIU, DBC, EEM, EFA, GLD, HYG, IWM, IWN, IYR, JNK, LQD, MDY, PCY, QQQQ, SHY, SPY, TIP, TLT

In the previous article, we discuss a simple hedging technique. In this part, we will discuss more effective ways to hedge.
A natural way to improve hedging technique is to use timing indicators as the guide to hedge or unhedge. Moving averages are one of the simplest and effective indicators. Using moving averages, one could start to short the chosen index ETF when the indicator gives a sell signal and then buy back the ETF when the indicator gives a buy signal. ValidFi's Momentum Hedge is a very good example to show that by using such a simple technique, one could achieve a reasonably good return while reducing the risk dramatically. In this strategy, a portfolio based on Sector Rotation Fidelity Select Funds strategy is used as the long portion of the portfolio while short position on SPY is taken based on whether SPY price is lower than the 130 days EMA (Exponential Moving Average) or 200 days SMA (Simple Moving Average). The following is the comparison of the long only portfolio and the hedged portfolio using 130 days EMA up to 9/1/2009.

		Last 1 Year (%)	Last 3 Year (%)	Last 5 Year(%)	Since 12/31/1993 (%)
Annual Return	Long Only	-11.83	-0.51	11.62	16.01
	Hedged	27.6	8.6	15.4	13.8
Sharpe Ratio	Long Only	-32.3	-7.6	35.69	55.07
	Hedged	120.5	32.1	62.7	51.3
Standard Deviation	Long Only	37.2	29	27	24.7
	Hedged	22.7	21.3	21.4	22.1
Maximum Drawdown	Long Only	34.9	47.5	47.5	51.1
	Hedged	13.9	20	20.4	49.6

Notice that maximum drawdown for the hedged portfolio improved in the last 1, 3 and 5 years but it has a huge 49.6% maximum drawdown since the inception date. This occurred during 2000-2001 period. This offers a cautious tale to hedge against a momentum driven portfolio: there might be still a period of time where some mismatched performances between the long and the short portions of the portfolio could be way too high to be tolerated.
Yet another way to hedge is to always short so called weak assets (or sectors) with a corresponding or a lesser amount. When shorting with equal amount as the long portion's, this is often called zero cost hedge as in theory (and for large institutions), the brokers would use the borrowed amount from the short sale to offset the long amount used. In ValidFi's Global Tactical Asset Allocation Momentum strategy, based on the original paper suggested, 100% short amount is used to short the worst performing three assets based on their past price performance while in the meantime keeping a long portfolio on the best performing three assets. For example, at the moment, the long part of the portfolio consists of VUSTX, GLD, VWEHX and the short part of the portfolio consists of VGSIX, VIMSX and VGTSX. Notice in this portfolio, we use index funds as the shorted indexes. In practice, one should substitute the above using ETFs equivalent. That would translate into long TLT, GLD, HYG and short IYR, MDY and EFA. The result is a mixed bag as one could see from here.
It should be noted that aside from the hedging, one could always perform tactical asset allocation (such as reducing or increasing the risky asset exposure) to avoid taking short positions. It is a simpler solution. The main reason to hedge instead of reducing the risky asset exposure by selling has to be that one believes the long portfolio could outperform the shorted index(es) during the possible market downturn. If this does not hold or it is hard to justify such an out performance, reducing or liquidating the positions is a better choice. The pros and cons should be weighed carefully.
One notable mutual fund which performs long and hedging is Hussman Strategy Growth Fund (HSGFX) managed by John Hussman. For anyone who is interested in the hedging techniques and Dr. Hussman's view point on current economic and market conditions, his weekly comments offer wealth of educational and prescient information.
In conclusions, some simple hedging techniques could go a long way to protect your capital while enhancing returns. In the current economic conditions, it is worthwhile to pay attention to them.

Labels: BWX, CFT, DBC, EEM, EFA, GLD, HYG, IWM, IWN, IYR, JNK, LQD, MDY, PCY, SPY, TIP, TLT