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The Power of Mean Reversion
Monday, February 14 2011 | 01:53 PM
|The more you look at it, the larger it looms. Yes, rebalancing is an old idea—buy low, sell high. But it's forever new for at least two critical reasons. One is simply bound up with the recognition that rebalancing works, or at least it has a long history of working by enhancing return while keeping a lid on risk. But it's not always clear what constitutes "optimal" rebalancing, or even if such a state of financial nirvana exists. That keeps analysts turning over rocks in search of progress.
As for real-world results, much depends on the definition of rebalancing. Factors such as timing, the composition of portfolio assets, and the rules that guide rebalancing activity vary quite a bit. Accordingly, so too does the degree of risk from rebalancing strategies. Yet it's also true that rebalancing in one form or another is behind a number of the new-fangled attempts to mint alpha.
The rise of rules-based indexing products in particular rely on rebalancing, even if that's not always clear. Some products emphasize technical signals, for example, that offer insight on when to rebalance. Other funds focus on changes in accounting-based metrics, such as sales, earnings, etc. But at the heart of many strategies is a common denominator: rebalancing.
Some of this bleeds over into other risk factors, which can blur the lines for deciding where rebalancing's influence ends and something else begins. But no matter how you dress it up, rebalancing is the foundation for most strategies that have a decent chance of delivering alpha over the long haul. The lesson applies to many strategies within a given asset class, and it's true for most multi-asset class strategies.
For the latter, efforts at earning alpha by dynamically managing a set of betas range from the routine to rocket science. But you don't need to a Ph.D. in engineering to earn a modest premium over a passive asset allocation. What you do need is a fair amount of backbone to buy out-of-favor asset classes and sell the winners. That's a dangerous pursuit with individual securities, but history and a small library of empirical research suggests this is a worthy strategy for most investors at the asset class level.
As a review of the possibilities, consider how the major asset classes stack up against one another in recent history and how those returns compare to some simple forecast-free rebalancing strategies (see table below). Note the wide range of return results over the past five years within markets, ranging from a 1% annualized return for a broad mix of commodities up to nearly 10% a year for emerging market stocks. Holding all asset classes in a passive, unmanaged mix in weights that approximate their respective market values earned 4.6% a year (BIR Global Market Index). If you rebalanced this mix every December 31 back to the allocation from the previous year, you earned more: 5.7% . Equally weighting the same portfolio by rebalancing to equal weights every December 31 did even better, delivering 6.7% a year. By comparison, the U.S. stock market returned an annual 2.5% over the past five years, based on the Russell 3000.
The lesson is that by diversifying broadly and dynamically managing the mix in a simple but straightforward manner, you can earn competitive results. That's hardly a secret. As I explain in some detail in Dynamic Asset Allocation, the finance literature has been telling us no less in recent decades.
Results will vary, of course, although a fair amount of the variation is under your control. If you can stomach more than average risk, you might consider an aggressive rebalancing strategy. Instead of mindlessly rebalancing on pre-set calendar dates, you can be more opportunistic by taking advantage of volatility as it comes. Rebalancing in the fall of 2008, for instance, rather than waiting for the markets to calm down. You might also rebalance in something more than mild form, or more frequently, or allocate among a more granular definition of asset classes.
In fact, the possibilities are endless for boosting the rebalancing bonus, but so too are the risks. Earning higher returns by systematically adjusting asset weights isn't a free lunch. You have to be willing to assume a higher risk than the average investor. The main hazard is linked to mean reversion in prices. History shows that this phenomenon tends to persist over time, particularly with broad asset classes. But there's always a question of whether it'll prevail the next time, or how soon prices will revert to their mean after a large change in the market. Such questions help explain why most investors find it hard to rebalance when market volatility is high. But that's why the expected return from rebalancing looks so rewarding.
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How To Implement An Effective Rebalancing Plan
Monday, February 07 2011 | 03:52 PM
|With all the media coverage of the leveraged ETF controversy that has been brewing over the past several months, it is becoming increasingly difficult to separate the facts from the fiction. As firm after firm bans the use of these funds, a growing number of investors are unable to utilize leveraged ETFs. For those who do retain the ability to use these funds, the horror stories of return erosion and flood of lawsuits might cause even the most sophisticated investors to steer clear. But while the dangers of leveraged ETFs (if used by those who fail to understand their risk profile) are very real, the potential upsides can be equally spectacular.
Of the countless misconceptions about leveraged ETFs, perhaps the most damaging is the notion that the returns on these products become wildly unpredictable when held over multiple trading sessions, due to the daily compounding of returns. While this can occur in certain markets, investors can implement a fairly simple process to ensure that leveraged funds will track the target multiple of their benchmark over longer time periods.
Most traders move in and out of leveraged ETF positions within a single trading session, as the objectives that they use these funds to accomplish are short-term in nature. But an increasing number of advisors have begun using leveraged ETFs over extended time periods to generate amplified returns on trends that may not play out in a single trading session. Since leveraged ETFs compound daily returns, returns over multiple trading sessions can often result in unpredictable returns, particularly in seesawing markets. But by using a relatively simple rebalancing plan, advisors can increase the likelihood that returns on leveraged ETFs will closely correspond to an intended multiple of the related index.
Leveraged ETFs 101
Leveraged ETFs use complex financial instruments, such as swaps and futures, to magnify the daily returns on a benchmark. For example, the ProShares Ultra S&P 500 (SSO) seeks to provide daily returns corresponding to 200% of the daily return on the S&P 500 Index. If the S&P 500 rises 1% for a single trading session, SSO should be expected to rise by about 2% (and it often does, as demonstrated in this feature).
Because leveraged ETFs seek to amplify daily returns, these funds reset their exposure on a daily basis. It is for this reason that when held for multiple trading sessions, the return on the leveraged ETF may deviate from the multiple of the return on the underlying index, particularly in oscillating markets. A leveraged ETF increases its exposure as its price rises and decreases its exposure as its price falls, leading to potentially undesirable results in a volatile, non-trending market.
Not Rocket Science
Many analysts and journalists convey leveraged ETFs as a mysterious black box that implements strategies beyond the grasp of most investors to generate erratic, unpredictable returns. In reality, the concept behind leveraged ETFs is easy to understand, and the consistency with which the funds achieve their stated objectives is rather impressive. Leveraged ETFs reset their market exposure on a daily basis, meaning that they are generally intended to be short term investments.
How To Optimize Leveraged ETF Returns
Some coverage on leveraged ETFs is correct: the effects on a portfolio in certain markets can be devastating if used incorrectly. But if used correctly, these ETFs can be powerful tools that can allow advisors to “double down” (or triple down) on anticipated movements in a benchmark. Advisors shouldn’t necessarily be scared of investing in leveraged ETFs for multiple sessions, but they should do so only if prepared to monitor the performance closely and potentially implement a rebalancing plan.
Leveraged ETFs are appropriate only for a relatively exclusive universe of investors for two primary reasons. The first is that since these funds are designed to amplify returns, they are likely to significantly increase the volatility of any portfolio that includes them, which may be inappropriate for risk-averse investors. Second, these ETFs require daily monitoring, since their performance over multiple trading sessions depends not only on the change in the related benchmark, but on the path of that index during the relevant period. Investors without the time or resources to monitor leveraged ETF investments on a daily basis should stay away from these products. The “set it and forget it” approach may work for long-term buy-and-holding, but it won’t work with leveraged investing.
As discussed above, leveraged ETFs operate with daily returns in mind, so bull funds must increase their exposure as the underlying index rises and decrease exposure as the markets fall. As a result, in seesawing markets leveraged funds will tend to return less than the multiple on the underlying benchmark when held for multiple periods, because a losing session will come on the heels of an increase in exposure and vice versa.
Consider this hypothetical example:
Period Index Value Daily Index Return 3x Leveraged ETF Price Leveraged ETF Return
Day 0 $100.00 ___ n/a ___ $100.00 ___ n/a
Day 1 $106.00 ___ 6.0% ___ $118.00 ___ 18.0%
Day 2 $100.70 ___ -5.0% ___ $100.30 ___ 0.3%
Day 3 $105.74 ___ 5.0% ___ $115.35 ___ 15.3%
Day 4 $102.56 ___ -3.0% ___ $104.96 ___ 5.0%
Day 5 $106.67 ___ 4.0% ___ $117.56 ___ 17.6%
Day 6 $101.33 ___ -5.0% ___ $99.93 ___ -0.1%
Day 7 $110.45 ___ 9.0% ___ $126.91 ___ 26.9%
Day 8 $106.03 ___ -4.0% ___ $111.68 ___ 11.7%
Day 9 $114.52 ___ 8.0% ___ $138.48 ___ 38.5%
Day 10 $110.00 ___ -3.9% ___ $122.11 ___ 22.1%
As shown above, the market rises 10% over a 10-day period, but a hypothetical 3x leveraged ETF tracking the benchmark would only rise 22.1%, or about 2.2x the return on the index. Depending on the level of volatility and period in question, returns on leveraged funds can deviate even further from the multiple on the underlying benchmark (note that on Day 6 the leveraged ETF had actually generated a negative return when the underlying index is up).
Again, since leveraged ETFs operate with daily returns in mind, their performance over multiple trading sessions can digress from the multiple on the underlying benchmark.
Rebalancing Is The Key
Contrary to popular belief, leveraged ETFs can be used to generate amplified returns over an extended period of time. But they can’t do it alone. (i.e., a “set it and forget it” approach won’t do the trick.) By implementing relatively simple rebalancing strategies, leveraged ETF investors can more closely approximate an amplified return on leveraged ETFs over multiple trading sessions.
By their very nature, bull leveraged ETFs increase exposure following increases in the benchmark index and decrease exposure when the index declines (as shown above). In order to achieve leveraged results beyond the short term, however, investors want to do the exact opposite. As the underlying index increases, advisors should reduce exposure by selling shares. As the index declines, advisors should increase exposure by purchasing additional shares. Consider the implementation of such a strategy assuming the same 10-day period:
Beginning ETF Investment Daily Index Return Ending ETF Value Daily Gain (Loss) Cash Withdrawal (Investment) Ending ETF Investment
$100.00 6.0% ___ $118.00 ___ $18.00 ___ $12.00 ___ $106.00
$106.00 (5.0%) ___ $90.10 ___ ($15.90) ___ ($10.60) ___ $100.70
$100.70 5.0% ___ $115.81 ___ $15.11 ___ $10.07 ___ $105.74
$105.74 (3.0%) ___ $96.22 ___ ($9.53) ___ ($6.34) ___ $102.56
$102.56 4.0% ___ $114.87 ___ $12.31 ___ $8.21 ___ $106.67
$106.67 (5.0%) ___ $90.67 ___ ($16.00) ___ ($10.67) ___ $101.33
$101.33 9.0% ___ $128.69 ___ $27.36 ___ $18.24 ___ $110.45
$110.45 (4.0%) ___ $97.20 ___ ($13.25) ___ ($8.84) ___ $106.03
$106.03 8.0% ___ $131.48 ___ $25.45 ___ $16.97 ___ $114.52
$114.52 (3.9%) ___ $100.98 ___ ($13.54) ___ ($9.02) ___ $110.00
Total Cash Flows $20.00
After the leveraged ETF rises on day 1, investors could reduce the position in the fund by pulling out two-thirds of the daily gain. After a decline on day 2, an additional cash infusion (again, equal to two-thirds of the daily loss) is required.
The strategy summarized above rebalances on a daily basis such that the ending exposure in the leveraged ETF is equal to the value of the index on that day. (Note that the far right column on the above table is equal to the second column on the first table.) After 10 days of volatile market returns, the investment in the leveraged ETF has increased from $100 to $110, and the advisor has taken a net amount of $20 from the investment, summing to a total return of $30, exactly equal to 3x the return on the index over the period.
The obvious oversight in this example is fees and expenses that would be incurred by such frequent rebalancing. This example is extreme in the sense that it implements a daily rebalancing strategy. The less frequent the rebalancing, the greater the tracking error and the lower the fees. In reality, it may be more sensible to set a “trigger point” at which point leveraged ETFs should be rebalanced (i.e., a deviation between the returns on the index and the return on the ETF). Unfortunately, there is no way around a trade-off between expenses and tracking accuracy when dealing with leveraged ETFs.
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