Keeping Your Balance - Why Active Management Is Crucial In Rules Based Investing

16th Oct '15 by Ben Hobson

6 comments 14566 reads

On our journey to build the very best data service and toolbox for investors, our team at Stockopedia has developed an investment philosophy. It’s obvious that investing is a very personal business; everyone is driven by different aims, timeframes and risk appetites. But we believe that getting to grips with a set of four broad principles can set investors on the right path to outperformance, and help them avoid the most common mistakes.

The first three principles in the Stockopedia philosophy focus on self-management and portfolio construction. Firstly, by managing the monkey, we begin by admitting the behavioural flaws which lead to bad decision making (from overtrading to hanging onto losers) and how we can put in place a process to combat them.

Secondly we focus on ensuring our stock selections are aligned with the factors that have pay off in stock markets (quality, value, momentum). Thirdly we make sure our resulting portfolio is adequately diversified across those selections - to ensure the portfolio plays well both in offence and defence.

The fourth and final rule - and the focus of this article - we call “Keeping your Balance”. Keeping your balance means taking a regular, cyclical and proactive approach to portfolio management to ensure it is well defended against the vagaries of the market. Crucially, it’s a reminder to avoid letting emotions guide decision making or allowing the portfolio to drift away from its intended objectives.

Weighting - keeping your portfolio in proportion

Deciding what proportion of a portfolio each stock should take is very much down to whether you’re a stock market hunter or a farmer. Stock picking hunters tend to apply detailed bottom-up analysis to each share. Depending on their conviction, they’ll weight their exposure to it accordingly. This is perfectly acceptable if you are very confident in your analysis.

On the other hand, farmers tend to construct portfolios of shares that aim to harvest factor returns. Decades of academic and professional research show that these main drivers of returns are oriented around quality, value and momentum. But what weight should each holding have?

Traditional UK benchmarks like the FTSE 100, the All-Share and the FTSE SmallCap are weighted by market capitalisation. In essence, this means that larger companies have a proportionately higher weighting than smaller companies. For many funds, particularly trackers that use these indexes as benchmarks, it makes sense to do the same as…

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gfkw47

19th Oct '15

Surely a calendar/threshold rebased portfolio is the same as a calendar based one. The rebasing happens at a predetermined day and is rebased using the selection criteria at the time? Is that not the case?

What I would like to know is, is there evidence to show that rebasing as soon as any particular share fails the selection criteria is better that simply sticking to a fixed period - whether it's a year or a few months? Can anyone help with this please?

Edward Croft

20th Oct '15

Surely a calendar/threshold rebased portfolio is the same as a calendar based one.

No I don't think that's right. The idea here is to only rebalance positions that have moved beyond a certain threshold on a certain date. This minimises transaction costs as you don't then need to make a trade in every position, you just trade in certain extreme outliers.

What I would like to know is, is there evidence to show that rebasing as soon as any particular share fails the selection criteria is better that simply sticking to a fixed period.

Essentially you are discussing 'sell rules' or stop losses. It's probably easiest if I discuss from the perspective of stop losses. The thinking behind stop losses is really capital preservation so that you 'know your risk' on any position and don't go beyond it. The academic evidence generally agrees that stop losses reduce downside volatility, but don't improve returns. So they are great for risk averse investors. The problem is that stop losses increase transaction costs, so you have to be careful and set stops at the right levels - far enough away that you don't churn your portfolio, but close enough that risk is managed and losses don't grow uncontrollably.

DYOR of course but personally I rebalance according to a calendar schedule (6 monthly but half staggered quarterly), and use mental stop losses in between to reduce my exposure gradually on weak performers.

Thanks Ed. for your input. However I am not simply concerned about stop losses - which I tend to create in my mindset rather that operating through my broker and set in stone.

What I am doing currently is to run a selection process every 3 months. This is using a screen based on "Best 100 stock ranks" but with some additional rules of my own. My rules include amongst others, that the value rank and the momentum rank and quality ranks should all be 80 or above. When I rebase by simply running the screen, I find that a number of shares owned no longer qualify, some still do and some new ones qualify.

I then divide the numbers of shares selected into the total value of the portfolio and sell shares that no longer qualify, modify holdings in shares that still do qualify either up or down as necessary, and buy shares in newly qualifying ones.

This means that at my next rebase I may end up with say 20 shares with £5000 (for example) invested in each or 10 shares with £10,000 invested in each. At the end of the next period if the portfolio has gone up to £120,000 and 12 shares qualify, I would carry out the above process so I have £10,000 in each of 12 shares.

This brings me to the difficult bit from my point if view.. Lets say that the momentum or the value for 3 shares has fallen to 60. Would you sell at this point or hang on until the rebase period comes around. And if the answer is sell once it falls out of the criteria for whatever reason - would you replace it with one that does qualify.

Thanks in advance

George

pka

21st Oct '15

Hi George, You wrote: "What I am doing currently is to run a selection process every 3 months. This is using a screen based on "Best 100 stock ranks" but with some additional rules of my own. My rules include amongst others, that the value rank and the momentum rank and quality ranks should all be 80 or above. When I rebase by simply running the screen, I find that a number of shares owned no longer qualify, some still do and some new ones qualify. I then divide the numbers of shares selected into the total value of the portfolio and sell shares that no longer qualify, modify holdings in shares that still do qualify either up or down as necessary, and buy shares in newly qualifying ones."

With respect, I think your rules are causing you to trade far too often and therefore you are incurring unnecessary transaction costs that will tend to significantly reduce your profits over the long-term. This is because your rules are causing you to hold a different number of stocks after each 3-monthly rebalance. I suggest that you modify your rules slightly, in a way that will enable you to keep the same number of stocks after each rebalance. For example, you could use the following rules instead of your present ones:

Use a screen based on 'best 100 StockRanks' but with the additional rules that the value rank and the momentum rank and quality ranks should all be 60 or above, and then select 25 stocks from that screen ordered by decreasing StockRank. That way you would always have 25 stocks in your portfolio after each rebalance, and initially the amount held in each stock would be 4% of the total value of your portfolio. Also at each 3-monthly rebalance, you would only completely replace a stock if its momentum rank, value or quality rank has fallen below, say, 40. But if a holding of a stock has increased to represent more than, say, 8% of the total value of the portfolio, you could reduce that holding to 4% and spend the proceeds on one or more stocks in the portfolio that still qualify according to the rules but each of which represents significantly less than 4% of the total.

Sorry, what I should have written in my previous post was: "Also at each 3-monthly rebalance, you would only completely replace a stock if it is no longer in the top, say, 50 in order of decreasing StockRank or if its momentum rank, value or quality rank has fallen below, say, 40."

Thanks pka - thats very helpful. I will take your advice and modify my holdings at the next re balancing .

Keeping your balance - why active management is crucial in rules based investing

Weighting - keeping your portfolio in proportion

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Ben Hobson

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