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The legendary founder of Vanguard asset management jack Bogle loved to wax lyrically about the idea of portfolio rebalancing.
It’s a simple concept that captures a surprisingly large number of insights. Let’s take a very standard 60/40 equities/bond portfolio. Let’s further say you have two funds representing them – £60 in Fund A for equities and £40 in Fund B for bonds.
At a set rebalancing point in time, which could be every week, every month or every year – you look at how Fund A and B have been doing. Lets’ say you opt for a yearly rebalance and at the end of year 1 Fund A has doubled in value while Fund B has only gone up by 10%. So Fund A is now worth is £120 while fund B is worth just £44. The total value of your fund is now £164.
You are obviously thrilled that Fund A has had a storming year, but you are also worried that it might be all too much of a good thing. And besides, you always wanted a mix – 60/40 – of equities and bonds. That was THE PLAN at the launch of the portfolio and it REMAINS the plan. So, at the end of year one you sell down £21.60 of your stocks and then reinvest this in Fund B (bonds). This brings our portfolio back to a 60/40 balance. After this rebalance we have £98.4 invested in equities and £65.60 invested in bonds. Total value £164, split 60/40.
This rebalancing exercise could be done more regularly, say every week, but at this point all those trading and commission cost start to eat into your returns. Every month is also fine but it still requires a fair bit of regular work to do the rebalancing. Some choose to do it quarterly whilst many others stick with the yearly rebalance.
Whatever timescale you use, you’re engaging in a number of processes
- You are taking profits from your winners and reinvesting in your losers. This in effect means you are selling high with valuations possibly stretched and reinvesting those profits in an alternative that might represent better value. This exercise in value investing is based on the idea that means reversion works over the long term i.e stuff that is too damned expensive doesn’t stay that way
- This exercise also manages to control risk by putting too much emphasis on the winners. In our scenario imagine what would have happened if our stock fund had quadrupled in price – hit £240 versus £44 for bonds. This portfolio would look hugely undiversified and lopsided.
There’s been a fair amount of academic to-ing and fro-ing about whether a) the regularity of the rebalancing and b) whether rebalancing adds upside returns.
In my Citywire column this week I run through a lot of the evidence back and forth in this debate and even I would say that the evidence is all over the place. Maybe stock markets have fundamentally changed during the last few decades of easy money and it’s better to stick with your winners. What I think is incontrovertible is that rebalancing helps to manage the downside risk of overexposure to one asset class.
Rebalancing is a useful exercise that some investors – but by no means all investors – utilize regularly. It’s also a bit fiddly to do and is obviously time-consuming. Therefore, although most investors say that they like the idea of rebalancing, they don’t actually do it. It’s just too boring.
Professional fund advisors of course regularly like to rebalance, partly because it manages downside risk but also because it shows they are doing some hard work for those fees. Wouldn’t it be nice to cut out the advisor and those fees and get someone else to do to the rebalancing for you ?
Cue a new ETF issued in the last few months in the US called the Discipline Fund ETF which describes itself as “a low fee, tax efficient globally diversified fund of funds designed to help you behave better and stay the course.” The idea here is elegantly simple. It invests in a small handful of broad Etfs from big names like Vanguard or State Street and moves around a fulcrum of 50/50 equities and bonds. But the exact mix and the nature of the rebalancing varies significantly.
Inception : 21/9/21
Net expense ratio : 0.39%
Number of ETF holdings : 6
Number of underlying holdings : 10,000+
Ticker : DSCF
Equities : 44%
Vanguard 500 ETF – 19.8%
SPDR Developed World Ex Us – 19.8%
Vanguard FTSE Emerging Markets ETF – 4.40%
Vanguard Intermediate Bond ETF – 28%
SPDR Portfolio Corporate Bond ETF – 14%
Vanguard Long Term Bond ETF – 14%
More details on the fund : https://disciplinefunds.com/what-is-the-discipline-fund/
So, how does this new ETF do its rebalancing ? The innovation here is called counter cyclical rebalancing which is described as
“… a strategy that rebalances its investments to reduce the pro-cyclical nature of a portfolio. Essentially, a countercyclical rebalancing methodology seeks to adjust a portfolio’s holdings to account for current market and macroeconomic conditions. In contrast, a standard passively-managed fund (which use pro-cyclical methodologies) will generally hold stocks and bonds in the same percentage allocation (e.g., a standard 60/40 portfolio) regardless of market valuations and macroeconomic conditions. The problem with a fixed approach like this is that it assumes that the 60% stock allocation is always exposed to the same amount of risk, when, in reality, we know that can vary over time. For example, a portfolio with 60% stocks in 2008 faced very different risks than a portfolio with 60% stocks in 2010 and while this approach may be perfectly fine for many investors it may also pose significant behavioral risks to investors who think they’re buying a “balanced” fund that actually has very unbalanced exposure to stock and bond risk.”
In practical terms this means that
“ …..When the stock market booms and the economy is doing well, the Discipline Fund is likely to become less aggressively positioned with the understanding that higher valuations generally correlate with lower future returns. Likewise, when the economy and stock market become depressed, the Discipline Fund is likely to become more aggressively positioned with the understanding that lower valuations generally correlate with higher future expected returns. When stock market risk is considered average, the Fund will generally allocate approximately 50 percent of its assets to the stock sleeve and 50 percent of its assets to the bond sleeve. The allocations may shift but will not exceed a 70-30 stock-bond allocation or a 30-70 stock-bond allocation….The Discipline Fund rebalances more dynamically than a static fund does which allows the fund to rebalance toward stocks when they appear more attractive and away from stocks when they appear less attractive. This helps better control for behavioral biases by aligning our asset allocation to the potential behavioral risks that the ups and downs of the market expose us to.”
I think this is an interesting approach and has many virtues. It’s simple. Its cheap. Its all automated for the investor. It accepts that some asset classes (equities) can become over priced and thus vulnerable to market turbulence.
I’m cagey about exactly how it decides on the criteria to move the levels around – what’s inside the black box that decides to go from say 55% equities to 45% equities? But assuming that the answer to that question isn’t complicated then I think this an idea that has legs. It is ideally suited to the long term buy and hold, forget about it core portfolio: a bunch of money you lock away and forget about. The true test will be how it performs with that counter cyclical rebalancing i.e trying to work out if a market is due a correction.
To my knowledge, there’s no equivalent UK fund for UK readers but I don’t think it would be too difficult to assemble a shadow portfolio with a similar configuration. Below I’ve outlined how one could build a two ETf portfolio with simple iShares building blocks. The key point is that I’d avoid all the difficult decisions about whether to have X % in emerging markets versus developed markets. Stick with an aggregate global equities index such as the MSCI ACWI index which incorporates the largest developed markets AND the largest emerging markets such as China and South Korea. Within bonds, again I’d keep it simple : use a broad Bloomberg Global Aggregate Bonds index. And how to decide to switch between the two. Use my dashboard above to see if markets are bullish or not. If you wanted a counter cyclical approach you could be 45% in equities when my dashboard is flashing bullish and 55% into equities when my dashboard is flashing red for a bear market.
Equities : Index ? MSCI ACWI (Accumulation) at 50%
ETFs: In the US ticker ACWI, in the UK SSAC, both from iShares
Bonds : Index ? Bloomberg Global Aggregate ex USD 10% Issuer Capped (Hedged) Index
ETFs: In the US ticker IAGG, in the UK a slightly different index called the Bloomberg Global Aggregate Bond Index with a ticker AGGU
An adventurous idea: Brevan Howard BH Macro
I think there’s a perfectly sound case for arguing that we may be in for a bumpy ride as equity investors in 2022. In particular I feel that the room for a policy error – by central banks or the Chinese government or even the US voter at the midterms later in the year – is substantial and growing by the week. And this all ignores other concerns about valuations
Now, I equally accept that I’ve been far too bearish for far too long and thus I’m entirely open to being wrong – with the US and UK markets powering ahead.
For the record my overall position is as follows
- US equities – neutral but still biased towards growth and tech stocks
- Sectors – overweight energy
- UK equities – buy
- European growth stocks – buy
- Japanese equities – cautious buy
- Bonds – bearish, avoid
- REITs – buy
What I think I can say with some certainty is that we are in a strange market where the bearish factors are increasingly obvious but not overwhelming, which perhaps helps explain why equities are still in a positive flux at the moment.
One possible insurance policy is to think about hedge funds. By and large I am deeply sceptical of most hedge funds. I tend to think that they are a) over rated for their alpha skills, b) charge too much and c) the only outfits you really want to invest in won’t want you. By the way the same logic applies to private equity. But there are exceptions to my general mistrust, one of which is Brevan Howard.
A few years ago the London stockmarket experienced a boom in the number of hedge funds listing sub funds on the LSE. The promise was compelling – alpha outperformance through alternative strategies. The reality was starkly different – most of the listed funds massively underperformed. But a few survived, notably two funds from London based hedge fund powerhouse Brevan Howard : HB Global and BH Macro. These two funds recently merged into one big fund BH Macro which I know own in one of my portfolios. In fact, I should explain that position – I have one tax wrapper (an ISA) which I pay in to on a monthly basis. In this pocket of investments, I have a more speculative attitude and want to be more careful with my market timing – with my other pockets of investments I’m much more long term and I’m generally happy just to drip feed cash into investments and not worry about market sentiment. This tax wrapper fund is currently at 40% exposure to the combined BH Macro fund precisely because I can’t work out where the markets are heading at the moment. And because I don’t have a clue, I’m happy to sit on the side-lines.
So why BH Macro ? First off, its now, in its combined state, big enough to be enough investor radars with a billion (sterling) in assets. Second there’s real evidence that Brevan Howard itself, is investing in building up its capability. According to a recent report by Jefferies fund analyst Matt Hose current AuM for BH is $17bn, up from $12bn at the start of the year and approximately triple the $6bn of AuM at its nadir. Internally the business has also made some big changes – Alan Howard himself has refocused back on managing money while the $7.7bn BHMF is now closed to new investment (thereby providing BHMG with scarcity value). Brevan has also added 21 ‘portfolio managers’ in 2021 across a number of strategies, taking total PMs to 83. According to Matt Hose “looking forward, significant growth in the core team is not expected, although Brevan will continue to build out satellite strategies, such as liquid credit, digital assets, and quantitative trading. In our view, this is giving Brevan more of an institutionalised look.”
So, to put it as simply as possible, with this listed fund you have access to first tier institutional hedge fund with a decent track record – note that its 5 year share price return is 77%. Moving forward BH is developing new skill sets but has a reputation for strong risk controls. That could be a winning strategy in an era where the chance of policy mistakes and macro upsets is likely to increase – all it needs are a few big breakout successes to push the share price forward 9although the flipside is also true, assuming the risk management system doesn’t kick in first).
Fund basics for BH Macro
- US dollar denominated shares ticker BHMU
- Sterling denominated shares ticker BHMG
- Share price £37.40
- Premium 9.4%
- Value £967m
- 1 year share price returns 6.2%
- 3 year share price returns 58.3%
- 5 year share price returns 77.2%
It’s always fairly difficult to find out exactly what the underlying BH funds invest in but at present the big positions in the listed fund seem to be shared between directional and relative value (RV) trading within BHMG’s underlying Brevan Howard Master Fund (BHMF) – 40% in each- with a further 20% in other strategies.
Crucially the shares have moved from an intermittent discount and small premium to a more substantial premium which is currently a smidgeon under 10%. I sense that’s a market vote for its strategy of making money on directional trades in a more volatile market.