Friday, January 14, 2011

Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part II of a Series)

In Part I, we laid out our approach to quantifying five investment techniques, and discussed the first technique, Optimal Asset Location.  Here, in Part II, we continue by evaluating two more techniques.


Technique #2: Overweighting toward small and value
Value: up to .50% per year

Many academic studies indicate that small capitalization stocks and value stocks produce greater returns over the long term, albeit at higher risk.  For a long term investor, this can be a boon – assuming the effect persists. 

In their pioneering studies, Fama and French found that overweighting portfolios with small and value stocks over long periods of time adds significantly to returns (Common Risk Factors in the Returns on Stocks and Bonds, Fama and French, Journal of Financial Economics, 1993; and The Cross-Section of Expected Stock Returns, Fama and French, Journal of Finance, 1992).  To quantify this effect for our purpose, we compared the return of an overweighted (‘tilted’) portfolio with excess small and value asset classes to a non overweighted portfolio with exactly the same proportions (the ‘un-tilted’ portfolio).  The ‘tilted’ portfolio returned 9.08% versus 8.22% for the ‘un-tilted’ one, a difference of 0.86%.  Thus, during the study period we see an improvement of 10.46% from the small/value effect. Since the small/value effect is only for equities, we scale the result by 60% (the portion of equities). Finally, we normalize for our study period and get an improvement of 0.50%.

Since the effect is difficult to see at low levels of diversification, most small/value aficionados invest in mutual funds or exchange-traded funds.

   
Technique #3: Whole portfolio, tax-sensitive rebalancing
Value: up to .55% per year

Rebalancing a portfolio means maintaining a specified asset allocation over time in order to maintain a consistent level of risk.  For instance, you might have 40% of your assets in domestic stocks, 20% in foreign stocks, and 40% in bonds.  If stocks went up more than bonds, you would need to sell some stocks and buy some bonds in order to maintain your desired level of risk.  Some experts also argue that rebalancing encourages you to sell asset classes that are at higher prices and buy those that are at lower prices.  Experts debate how frequently you should rebalance, with some arguing for every three months, and others recommending every 12-18 months.

Most investors have multiple accounts, both taxable and non-taxable (e.g. IRA, 401(k), etc.). Many investors – and even some advisors – rebalance account by account.  This achieves the desired level of risk, but leads to higher taxes.  Whole portfolio rebalancing considers the tax consequence of the trades — buys and sells — required to get a portfolio back in balance so maximum tax advantage is achieved.  The total of each asset class from all accounts is considered.  If there is an excess of an asset (i.e. it is above its desired threshold), tax-sensitive rebalancing will first look for that asset in taxable accounts where there is a capital loss, with short term losses preferred over long term ones.  Next to be considered are sales of that asset in non-taxable accounts (the proceeds from the sale will remain in the non-taxable account, of course, unless a distribution is desired).  Last to be considered are sales from taxable accounts where there is a capital gain, with long term gains preferred over short term gains.

The study Opportunistic Rebalancing: A new Paradigm for Wealth Managers (Daryanani, Journal of Financial Planning, 12/2008) found, over the period from 1992-2004 where the market returned 8%, that an annualized improvement of 0.50% could be achieved with rebalancing. The study attributed this improvement to two effects:

  1. Rebalancing as much as possible in non taxable accounts (to avoid taxable gains), the investor improved returns 0.22%;
  2. Using the “opportunistic rebalancing” techniques described in the above study, the investor achieved another 0.28% improvement.
Normalizing for our period, we get a 0.55% improvement (0.55% = 0.50%/5.84% x 8.76%).

But there’s a caution.  Properly doing whole portfolio rebalancing, even with the help of a spreadsheet, can be a nightmare.  Some advisors pay thousands of dollars per year for rebalancing software; we sensed an opportunity to do a better job, so we wrote our own, an effort few investors can justify.

In Part III of the series, we’ll consider the final two techniques, and draw our conclusions.

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