Alternative Strategies For Re-Balancing Index Based Portfolios

Passive investing

Many investors turn to index investing as a relatively easy and cheap way to invest their savings. Doing so is very easy:

  • Build a portfolio of ETFs or Index Funds.
  • Decide on the proportion each security will get.
  • Re-balance them every year or quarter so that they match your original portfolio model.

This technique is very popular and a lot of interesting articles and blogs exist on the subject presenting many index based portfolios:

Many people think this is optimal because they claim you cannot time the markets and beat the indexes (See efficient-market hypothesis). Thus, re-balancing or buying more of a position that is in a clear downtrend makes sense to them. In my opinion, re-balancing at regular interval in order to keep an arbitrary fixed allocation to each security over a long period of time, while better than no re-balancing at all, is not optimal.

The examples that follows are using Vanguard index funds mostly because the data I have goes way back to the 90s, you should be able to use comparable ETFs to get similar results. First, lets look at a comparison of a very simple portfolio of 60% VFINX (SP 500 index fund) and 40% VBMFX (Bonds) since 1997 while we re-balanced every quarter compared to doing no re-balancing at all.

Note: The performance graphs in this post do not include dividends

Funds Rebalancing Strategy Total Returns Compounded annual growth rate Drawdown
VFINX(60%)
VBMFX(40%)
Static,every quarter 207.45% 6.89% 34.79%
VFINX(60%)
VBMFX(40%)
No rebalancing 188% 6.48% 34.76%

static_and_no_rebalance

What do we see in this table and graph?

  • The 60% stocks and 40% bonds allocation outgrows the SP500 index in the ~15 years period covered by the test.
  • The portfolio using the static re-balancing strategy has slightly better returns compared to no re-balancing at all.
  • The drawdown, at 34% is quite big.

 

How can we improve this strategy?

Let’s add some Enhanced indexing to our strategy. For example, we would like to be out of the markets tracked by our ETFs or Funds when they are in a major down trend to reduce risk and keep our gains, how can we do this?

The re-balancing strategy can be enhanced by applying a filter based on a widely used technical indicator, the 200 days moving average: When one of your security is below its 200 days moving average, sell it and stay in cash, when it gets above the 200 days moving average buy it back. Lets look at VFINX, the red dots mean that you should sell, the green dots mean that you should buy as the asset is back on a uptrend. Of course there will be false signals, but the important, real big trends, are not missed.

vfinx_200_ma

 

Cash is a position

Let’s add this strategy to our original table to see how it performed, every quarter, for each security:

  • Hold using its original allocation, rebalance if needed (VFINX: 60%,  VBMFX : 40%) ONLY if  the asset price is above its 200 days moving average.
  • Sell  using its original allocation ONLY if  the asset price is above its 200 days moving average. So if VFINX is below its 200 days moving average, you should be 60% in cash for that quarter, if both VFINX and VBMFX are below their 200 days moving averages you should be 100% cash.
Funds Rebalancing Strategy Total Returns Compounded annual growth rate Drawdown
VFINX(60%)
VBMFX(40%)
Static,every quarter 207.45% 6.89% 34.79%
VFINX(60%)
VBMFX(40%)
No rebalancing 188% 6.48% 34.76%
VFINX(60%)
VBMFX(40%)
Cash Position When Below MA 203.97% 6.82% 9.95%

cash_position_when_below_ma
As you can see, there are no real improvement in the total return, but did you see the improvement in the drawdown? We went from 34.79% to 9.95%. It means that from 1997 this portfolio would never have lost more than 10% of its value going through the dot com bubble and the 2008 financial crisis.

Buy more winners!

Let’s see if we can improve our “cash when below MA” strategy, what if instead of remaining in cash, we redistributed our cash positions into other winners in our portfolio? For each security:

  • Hold using its original allocation, rebalance if needed (VFINX: 60%,  VBMFX : 40%) ONLY if  the asset price is above its 200 days moving average.
  • Sell using its original allocation ONLY if  the asset price is above its 200 days moving average. So if VFINX is below its 200 days moving average, you should be 60% in cash for that quarter, if both VFINX and VBMFX are below their 200 days moving averages you should be 100% cash.
  • Re-Invest the cash equally between “in market” positions, so if VFINX is below 200 MA and VBMFX above 200 MA, use the 60% cash from VBFINX to buy VBMFX, this means you will be 100% VBMFX.

Of course you might not want to allocate 100% of your portfolio to a mining ETF for example, so later on we’ll see what we can do about that, but for now let’s just stick with VBFINX and VBMFX.

Funds Rebalancing Strategy Total Returns Compounded annual growth rate Drawdown
VFINX(60%)
VBMFX(40%)
Static,every quarter 207.45% 6.89% 34.79%
VFINX(60%)
VBMFX(40%)
No rebalancing 188% 6.48% 34.76%
VFINX(60%)
VBMFX(40%)
Cash Position When Below MA 203.97% 6.82% 9.95%
VFINX(60%)
VBMFX(40%)
Redistributed Position When Below MA 309.47% 8.73% 11.87%

As you can see, we retain a very small drawdown of 11.87 and we improved our compound annual growth rate by almost 2%!
redistribute_when_below_ma

Making it even more interesting

Up to now, all the test cases were using a portfolio of only 2 securities, let’s spice things up a bit and try the same back tests with the following portfolio, the only difference is that we introduce a Max Allocation parameter which limits the absolute maximum allocation each securities in the portfolio can have which helps reduce risk by preventing over allocation in a risky security:

Funds Base Allocation Max Allocation
SP 500 Index VFINX 35% 100%
Total Intl Stock Index VGTSX 20% 100%
REIT Index VGSIX 10% 100%
Precious Metals and Mining VGPMX 5% 15%
Total Bond Market Index VBMFX 30% 100%

Here are the results:

Rebalancing Strategy Total Returns Compounded annual growth rate Drawdown
Static,every quarter 221.87% 7.18% 43.58%
No rebalancing 188.11% 6.48% 46.01%
Cash Position When Below MA 198.25% 6.70% 13.56%
Redistributed Position When Below MA 368.65% 9.60% 15.60%

position5_full

Having a more diversified portfolio seems to favor the Redistribution strategy as well with a very respectable 9.6% compound return.

Commission cost, taxable gains and other caveats

Here is a list of potential issues I can think of with this strategy:

  • Since this strategy means you will have to do a bit more transactions, if you have a small amount invested and/or a greedy broker, you should seriously how the commission fees will affect your returns.
  • Depending in which account you are holding the portfolio, selling securities can have serious tax implications,  be sure to understand what they are.
  • Re-balancing every quarter means that you can miss a big drop in a security by about 4 months, which can be detrimental. But at the same time, it can help you ignore false signals. Many phone apps and websites support alerts based on technical indicators, each security in your portfolio could have an alert when its price goes below 200MA so you can act on it. I ran the same test with a 5 days re-balance interval to see how it would be affected and the CAGR from the last test dropped from 9.6% to 8.69% while the drawdown jumped from  15.60% to 19.89% both negative changes are probably caused by the increase in false signals caused by the smaller re-balancing window. But the strategy is still giving superior results.
  • Anytime you increase the base allocation of a position  in your portfolio you should take every step required to feel comfortable about it, if you cannot sleep because of it, reduce your position or add a stop loss. You can also fall back to the “Cash when below 200MA” strategy, that will at least reduce the drawdowns significantly for a relatively small cost in performance.
  • Dividends, I couldn’t find a reliable source of dividend distribution data yet, I would be very curious to see these graphs updated with the dividends.
  • Other refinements could be done such as taking into account the base allocation when redistributing the cash into the active positions.

 

Conclusion

I think “redistributing when below 200MA” and “cash when below 200MA” strategies are very interesting concepts to add to one’s investor toolbox.  I’ll continue experimenting with these concepts and write a new article about it if I find anything interesting.

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