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

Ben Hobson

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 they are oriented for ‘scale’. But for an investor that wants to beat the index, this approach simply doesn’t work.

By definition, a market-cap-weighted index has a larger weighting in shares that increase in value and a smaller weighting in shares whose prices decrease. The problem with that - as Joel Greenblatt explains in The Big Secret for the Small Investor - is that when Mr Market gets over-excited about certain companies and overpays, their weighting in the index rises. So the index fund ends up being more heavily weighted in overpriced stocks. And when Mr Market is pessimistic about certain companies, the opposite happens. They can fall below fair value and the index ends up owning less of these potentially bargain-priced stocks.

The importance of Greenblatt’s observation was starkly illustrated in research conducted by Cass Business School in 2013. Using data on the 1,000 largest US stocks every year from 1968 to the end of 2011 the researchers compared the performance of a set of alternative indexing approaches. That involved simulating the performance of 10 million portfolios to see what worked best. What they found was that randomly selected equal portfolios delivered vastly superior returns to market cap-weighted portfolios. But both of these were beaten by portfolios that were either equally weighted or tilted towards specific factors, such as low volatility.

The equal weighting advantage

So, for individual investors who don’t want to use their own conviction to decide position sizes, the evidence suggests that equal weighting is a sensible place to start. Equal weighting breaks the link between market prices and portfolio weight, which is so common in the fund management industry. Doing that boosts the opportunity to harvest excess returns from smaller and more attractively valued stocks, while avoiding the index-fund peril of systematically investing in expensive, momentum stocks.

While evidence favours an equal weighting approach, it’s important to remember maintaining equal weighted positions may incur more work and more trading costs. As a result, keeping your balance also means having a clear strategy when it comes to rebalancing the portfolio...

Rebalancing - avoid drifting away from the goal

Rebalancing means adjusting a portfolio so that it's weighted and diversified according to the original plan. Even if you do nothing with a portfolio, its initial weights will slide out of balance over time as share prices rise and fall. Traditionally, investors have been warned about this kind of drift because of the risk of being overexposed to individual positions.

In a factor-focused strategy - particularly one that uses value and momentum - there is an inherent risk of style drift without rebalancing. What that means is that value stocks that rise in price will eventually cease to offer the value premium any more. Likewise, momentum, which may last for up to a year, will eventually fade. With the portfolio no longer exposed to those factors, it's clear why regular rebalancing is needed.

Some analysts have even suggested that rebalancing can be a source of extra returns because of something called ‘volatility harvesting’. Here, regularly trimming back shares that have risen in price and channelling funds into shares that are still cheaply priced, takes advantage of short term over and underpricing of securities. Rebalancing literally harvests additional returns from short term over and under exuberance in share prices.

Both stock market hunters and farmers can sometimes be wary of rebalancing because it contradicts advice that you should cut your losers and run your winners. The short answer is that unless you’re an above average stock-picker who can control the emotions of fear and greed and expertly time the sale of investments, some form of rebalancing may well help to manage risk.

When to rebalance?

Calendar rebalancing

Many market professionals and guru investors endorse the idea of rebalancing. A common suggestion - from fund managers like James O’Shaughnessy and Joel Greenblatt and financial theorist Robert Haugen - is to turn over a portfolio no more than once annually. Others suggest half-yearly, quarterly or even monthly depending on portfolio size and status.

In theory calendar rebalancing helps to maintain the discipline of routinely looking at how the shape of a portfolio has changed. On the rebalancing date, in a rules-based strategy, new candidates that qualify for the rules will be bought, while those that no longer qualify will be sold, while of the holdings that still qualify, the winners are trimmed back and the funds are channelled back into the rest.

Threshold rebalancing

An alternative approach to rebalancing is to make adjustments only when individual stocks get way out of whack from their original target allocation. Regardless of whether the threshold is to reduce positions when they become greater than 5%, 10% or 20% of your portfolio, you’re basically letting the portfolio guide the rebalancing decision rather than waiting for a specific day in the year. This is a more proactive and risk-averse approach than calendar rebalancing because it acts quickly to stop a portfolio becoming too heavily weighted in individual stocks. However, in portfolios of particularly volatile stocks it could lead to excessive trading.

Calendar & Threshold rebalancing combined

A potentially happy medium is to apply threshold rebalancing on a fixed timeframe. In other words, review the portfolio periodically and only rebalance the stocks that have moved beyond the pre-set thresholds. Depending on the size and nature of the portfolio, this could help limit the trading costs that might be incurred by simply relying on threshold rebalancing, while allowing room for individual positions to grow before clipping their wings. Again, it depends on the nature and the volatility of the stocks in the portfolio.

Top-up rebalancing

A fourth rebalancing option is one that applies to investors who regularly deploy new funds to their portfolio (perhaps making use of the annual ISA allocation), as well as those that re-invest dividend income. In this instance the new funds are directed at hitherto underperforming stocks (again, assuming that those shares still qualify for the strategy rules). The advantage of tactical top-ups is that they can partially, or even fully, rebalance the portfolio without incurring any of the costs of having to sell down positions first.

Deciding on the best rebalancing strategy is entirely personal and dependent on several key factors as follows:

Rebalancing factor 1: Portfolio value

The greater the value of your portfolio the lower the relative cost of trading those shares will be. As a result, the size of your portfolio in value terms can be a big influence on the cost-effectiveness of regular rebalancing. Share purchases incur broker commissions (of around £10 per trade) and stamp duty of 0.5% (unless it’s an AIM stock). Commissions will also be levied on sales, too. Research has shown (Barber & Odean) that high levels of trading are a major contributor to portfolio underperformance.

Rebalancing factor 2: Tax

If you are investing through a tax-efficient wrapper like an ISA or a SIPP you can buy and sell shares without incurring Capital Gains Tax and potentially trade more frequently. If you aren’t, then CGT is likely to have a very considerable bearing on the regularity of your rebalancing. In the 2015/16 tax year, the the annual CG tax-free allowance is £11,100. If you crystallise gains (net of losses) beyond that figure then you could be paying tax at either 18% or 28% on your profits. Obviously that’s undesirable and will possibly wipeout whatever theoretical gain was imagined when the rebalancing took place.

In addition, and depending on individual circumstances, there is also the risk of incurring an awful lot of paperwork. Records need to be kept of sales for CGT purposes. Bear in mind that when you trim a winning position you’re retrieving part of the original capital and part of the gain, so a tight audit trail is needed.

Rebalancing factor 3: Spreads

The third factor to consider in a rebalancing strategy is the size and liquidity of the stocks in the portfolio. The crucial point here is the bid-ask spread. This is the difference between the price that’s quoted to buy the share and the price that’s quoted to sell it. It’s another trading cost and one that is influenced mainly by the availability of shares to buy and sell.

Generally, large cap stocks have narrower spreads than small stocks. Indeed, some low liquidity small-cap stocks can have exceptionally wide spreads that make them difficult and expensive to trade.

Rebalancing factor 4: Style factors

There are value investors and there are momentum investors - both are persistently successful approaches validated by academics and practitioners. What few investors realise though is that they often work across different timeframes.

Buying value stocks requires a patient approach, and it’s not uncommon for value investors to hold bargains for two or three years before the value ‘outs’. In contrast, momentum tends to persist over a three month to one year timeframe. Holding momentum stocks for too long can end up being risky.

Constructing a sensible rebalancing strategy should take your style timeframe into account. A combined value and momentum strategy should balance between the longer term value effect and the shorter term momentum effect… again a good ballpark may be a one year holding period.

Keeping your Balance - key facts

There are numerous strategies for rebalancing a portfolio to keep it correctly weighted - whether it’s carried out on a fixed time frame or when a position hits a certain percentage size. But in deciding on an approach it’s important to take account of the potential costs that could be incurred. Tax, fixed trading fees and indirect costs that can escalate depending on the nature of the stocks in the portfolio need to be watched carefully. That way rebalancing can help you manage risk effectively and control the weighting of the portfolio without unnecessarily damaging your profits.

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