The Question on Everyone’s Mind

In the 3rd quarter of 2012, the broad US stock market (S&P 500) was up 5.8%. The US bond market, as measured by the BarCap Aggregate Bond Treasury Total Return Index, was up a tenth of that, with a gain of only .57% for the quarter.

This raises a huge question for portfolio managers and the ways in which they’ll answer it will vary considerably.

Most of the money in the stock market is institutional – by which I mean it is retail money that is managed by institutions. It is guarded, stewarded and invested by professionals with varying degrees of rules-based discipline and always with an eye on the calendar. Today is the beginning of Q4 and almost everyone who manages money professionally is asking themselves the same thing – should we rebalance? I’ll explain why.

Most professionals in this day and age were schooled in some form of Modern Portfolio Theory (MPT). This comes with some obligation to maintain strategic weightings across asset classes and sectors, regardless of the “behavior” of the markets. The asset management complex is not schooled in trend following, by and large.  Instead, it has been indoctrinated into a practice of  selling assets when they are “high” (at least when they are high relative to others) and then redistributing that cash into assets that have declined in price. The idea is to preserve intended weightings and to rebalance frequently enough so that an overweight doesn’t become a runaway train.

By the way, this is the whole idea of a traditional 60/40 equity – bond portfolio.  In 2009 you would have been selling bonds and adding to stocks in order to get back to the 60/40 intended allocation. And it would have worked.  Similarly, you would have been selling to equities and adding to bond positions in 1999, as painful as it would have seemed to have left that particular party. This also would have worked in your favor.

Anyway, most professional asset managers have this decision to make this week, the first few days of Q4, and it is not an easy one. There are managers who do this quarterly rebal automatically, without thinking, in a hyper-disciplined way – and that’s their prerogative.  There are others who only do semi-annual or annual rebalances so as not to miss out on bigger trends during the course of a given year.

But there is a third group, the guys who pick and choose when the most rational time is to do rebalancing trades, accounting for the fact that the calendar can be very inconvenient at times and oblivious of the on-the-ground situation.  Proponents of regular rebalancing (typically, they are Efficient Market Hypothesis guys and indexers as well) would tell you that this obliviousness is precisely the point – a rule keeps you from letting recent headlines or market moves sway a decision.But the optional rebalancing camp would say that they are more concerned with market internals, momentum, potential risks and catalysts, and the larger cycles that govern macroeconomics, government and central bank policy and corporate decision-making. They argue that the first of the quarter is a date falling arbitrarily in the midst of much more important considerations.

Who is right?

As usual, this becomes a question not just of ideas and theories but one of execution.

Where it gets interesting this year is the way in which the Q3 rally knocked everyone on their asses. Most were unprepared for it and many spent the majority of their efforts seeking to discredit it or find fault with its enthusiastic participants.

And now, it gets even more complicated due to the huge outperformance of stocks over bonds. The asset allocator raised on rebalancing and nurtured on broad diversification is faced with this question. Sell stocks just as the market breaks to fresh four year, post-crisis highs? Buy bonds just as the ridiculousness of sub-2% income on ten-year paper becomes apparent to everyone?

Not an easy decision, even if the rules you’ve laid out demand it.


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