fixed-income securities with different maturity dates designed to mature reg- ularly over a defined period of time that can range from 1 to 20 years. When the shortest security matures, it is replaced with a purchase of an equal amount of the longest maturity in the ladder. Laddering tends to outperform other bond strategies because it simultaneously accomplishes two goals: (1) captures price appreciation as the bonds age and their remaining life short- ens, and (2) reinvests principal from maturing short-term bonds (low-yielding bonds) into new longer-term bonds (high-yielding bonds).
Laddering also reduces interest rate risk because it shortens the average maturity of a portfolio, which reduces the portfolio’s reaction to changing interest rate conditions.
designated time period. The asset class weightings of each portfolio are listed in Tables 7.4 and 7.5.
The following performance is based on a buy-and-hold (with annual rebalancing) strategy since 1970 and does notinclude the impact of taxes or expenses of any kind.
100 THE PROCESS
FIGURE7.7 Portfolio 3—Growth.
FIGURE7.6 Portfolio 2—Balanced.
Asset Allocation 101
By averaging the worst four quarters and years (Table 7.6), the extreme results of any given period are eliminated. However, in point of fact, there were declines of greater magnitude than are illustrated here. It is therefore necessary to fully understand the range of available returns to accurately assess your risk tolerance.
It’s very surprising to notice how a small increase in the internal rate of return creates significant increases in risk. If you notice that your level of FIGURE 7.8 Portfolio 4—Aggressive. The U.S. Large Cap and Small Cap Should Be Equally Weighted between Growth and Value.
TABLE7.4 Portfolio Weightings*
Large Small International
Stocks Stocks Stocks Bonds
Conservative 20 10 10 60
Balanced 30 15 15 40
Growth 40 20 20 20
Aggressive 50 25 25 0
*All numbers are percentages.
decline tolerance exceeds the average of the worst four quarters, please remember that we’re not taking a snapshot of what happened through the quarter, and that certainly there were periods where you were down a lot more in the course of the quarter than the number you see in Table 7.5.
The final step of the asset allocation process entails quarterly performance reporting on the total plan as well as each separate account manager. Specific indices for comparison are selected by the sponsor and recommendations to keep or fire the separate account managers are made periodically.
102 THE PROCESS
TABLE7.5 Returns of the Portfolios
Aggressive Growth Balanced Conservative
Rate of return 14.2 13.2 12.2 11
Beta* 0.99 0.82 0.65 0.48
Average worst 4 quarters −15.6 −12.22 −8.9 −6
Average worst 4 years −20 −16.3 −12 −8.3
*Beta measures a stock or portfolio’s volatility compared with the market as a whole.
The S&P 500 is used as the benchmark for measuring the beta of a stock or portfolio. If the benchmark is 1.0, a beta of 1.1 indicates that your stock is 10 percent more volatile than the market. A beta of 0.9 indicates that your stock is less volatile than the market as a whole.
TABLE7.6 Individual Asset Classes
Average of Average of Rate of Worst Four Worst Four Return Beta Quarters Years
Large-cap growth 12.9 1.13 −29.7 −29.7
Large-cap value 15.6 0.83 −17.6 −10.9
Small-cap growth 8.97 1.4 −29.5 −28.8
Small-cap value 17.6 1.1 −23.2 −18.4
EAFE 13.2 0.75 −19.5 −17.8
Long-term government
bonds 8.94 0.25 −10.3 −5.8
Short-term government
bonds 7.78 0.0 −.4 3.8
Source: The data is from Ibbotson Associates, Inc., from 1970 to 2001.
Most of your clients assume one style will always be in favor.This is not the case. Every manager style has its rotation or cycle. Some say a typical capital market cycle is 45 months from trough to trough, and that no manager style will perform well for more than two-thirds of that cycle, or 2.5 years. Others say a manager performs well for six to eight quarters (1.5 to 2 years) and poorly for eight quarters (or 2 years). Whatever the amount of time, the key is to understand that manager performance among various investment styles goes in cycles.
How can you maintain the same percentages in your asset allocation to maintain proper diversification?You rebalance. Many large pension funds rebalanced their equity positions down to their allocation targets as the bull market pushed equity values upward. Then, during the last two years or so, they increased equity positions as the declining markets dropped those posi- tions below targets. As a result, they have been selling high and buying low.
See the logic? When the price is down, you are able to buy more shares. Plus, you’re reinvesting the money you’ve made along with your principal, and compoundingyour growth.
Although the mechanics of rebalancing are fairly straightforward, there are an infinite number of methods that could be used to reach that optimal portfolio goal of maximizing returns while minimizing risk. From a theoreti- cal standpoint, two questions arise: Is rebalancing effective? And, how often should one rebalance?
These are five techniques using 23 years of data (the Russell Indices) to compare their effectiveness and the differences between the frequency of rebalancing annually and quarterly.
“Let It Ride.” This is a passive rebalancing strategy. Under this strategy, the investor simply sits back and allows the style rotation to occur with- out interference; the market cycles do the rebalancing.
“Back to the Start.” This strategy involves rebalancing all styles back to the original allocation. In the case of diversification equally across six styles, each would be rebalanced to 16.7 percent every time rebalancing took place.
“Tolerance.” This strategy is similar to “Back to the Start,” but it allows a predefined tolerance level around the original allocation percentage.
For example, a 2 percent tolerance level would allow each style to vary between 14.7 and 18.7 percent. At each rebalancing interval, only those styles that had declined below 14.7 percent of the overall portfolio or increased to greater than 18.7 percent would be rebalanced.
Asset Allocation 103
“Robin Hood.” Just as Robin Hood stole from the rich and gave to the poor, this strategy involves taking the gains from the style with the highest weight (highest proportion of the overall portfolio) and giving those gains to the style with the lowest weight at the time of rebalanc- ing. This strategy results in rebalancing only two styles: the one with the highest weight and the one with the lowest weight.
“Reverse Robin Hood.” This is the strategy unknowingly applied by most individual investors. They usually reduce their holding in the style that has declined the most and increase the style that has recently gained the most. This tactic is known as “chasing the hot dot.” (See Figure 7.9.) When comparing the risk/return matrix for each of the five strategies based on rebalancing annually, three strategies produced similar results: “Let It Ride,” “Tolerance,” and “Back to the Start.” However, the other two stand out. The “Robin Hood” strategy improved returns and reduced the standard deviation. The “Reverse Robin Hood” strategy detracted from performance and increased volatility. (See Figure 7.10.)
When increasing rebalancing frequency to quarterly from annual, the pas- sive “Let It Ride” strategy did not change its results. The two strategies most similar to the passive strategy produced similar results. “Tolerance” and 104 THE PROCESS
FIGURE7.9 Rebalancing Annually.
Source: FactSet.
Asset Allocation 105
FIGURE7.10 Rebalancing Quarterly.
Source: FactSet.
FIGURE7.11 Growth of $100,000.
“Back to the Start” both offered approximately the same return as with annual rebalancing. However, the results for the other two strategies were dramatic. The “Robin Hood” strategy improved the return by almost 1 per- cent over the same strategy rebalanced annually, and reduced standard devi- ation by almost 0.5 percent. The “Reverse Robin Hood”decreased returns andincreasedrisk. (See Figure 7.11.)
The study shows that more frequent rebalancing improved results, which would indicate that a style that is outperforming the broad market does not stay in favor for long periods of time. The same holds true for a style that is underperforming the broad market: Its out-of-favor status does not sustain for long periods of time.