The Short Version:
Volatility and Rebalancing: Volatility is uncomfortable, but can be beneficial to portfolios as long as they are rebalanced regularly. We’re slightly deferring rebalancing now because of the spike in volatility, but plan to do so soon.
An Important Defensive Move: We conclude that there is unusually high risk in European financials now, and we are taking several steps in portfolios to reduce exposure to that risk. [For more detail, please see below.]
Volatility and Rebalancing
As you are well aware, stock markets sometimes slip into panic mode during which, for a while, price volatility explodes. We've certainly been in one of those phases recently.
Volatility is disconcerting. We understand it's uncomfortable when fear dominates for a time. But volatility also has important portfolio benefits. For one, stocks only offer better long term returns than bonds because they are generally more uncertain. And these periods when markets become unhinged are a big part of that uncertainty.
Moreover, the returns of balanced portfolios benefit from volatility as long as they are rebalanced with discipline. That may seem counterintuitive, but it's true. To illustrate, here's an example of the last 7 years with returns from just two asset classes: stocks (S&P 500) and bonds (taxable):
Assume that given an investor's circumstances and risk tolerance, a mix of 50% stocks and 50% bonds was considered appropriate. Over the period, stocks returned 6.7% per year and bonds returned 5.0%. You might expect a 50/50 blend would have returned 5.85% per year over this period - the average of 6.7% and 5.0%. However, the 50/50 mix with quarterly rebalancing actually produced a return of 6.2%, which is 0.35% per year more than the average. This extra return “bonus” comes from three things: volatility, less-than-perfect correlation among the assets, and regular, disciplined rebalancing (because of buying low and selling high as asset classes vary in price against each other). This is sometimes called “rebalancing return”, and it’s very important over time. And that’s especially true in a low return environment: over this particular period, it boosted cumulative returns by 6%. In dollars, for a $2 million account in 2003, this additional return would have amounted to more than $9,000 per year in additional gain (before taxes and transactions costs). This extra return increases as both the degree of correlation among a portfolio’s assets decreases and as volatility increases. Moreover, it disappears altogether if regular rebalancing does not occur.
So, greater volatility of at least some assets in a broadly diversified balanced portfolio means greater “rebalancing return” (if rebalancing occurs). Volatility is uncomfortable, especially at recent elevated levels, but you may take some solace in knowing that volatility is an important source of extra returns.
This illustrates why we consider regular disciplined rebalancing so important. The appropriate question is never IF we should rebalance, only HOW best to do so.
In that regard, we note that there is one circumstance when it is usually beneficial to defer rebalancing a bit, and that is when market volatility has spiked up, as it has recently. Intermediate stock market bottoms are generally associated with spikes in volatility as measured by the “VIX” index, or Chicago Board Options Exchange Market Volatility Index. That index measures S&P 500 Index expected price volatility over the next 30 days as implied by options prices, and has been available since 1990. “Panic spikes” in that index have all been associated with market bottoms, but have usually preceded the actual bottom by a few weeks (sometimes more). On average, a small benefit generally accrues from deferring rebalancing purchases by a bit, on average after such spikes in volatility.
What are we doing now?
By some measures, stock valuations are better now than we’ve seen since 2009 and the recent spike in market volatility qualifies as a “panic spike”. So, we have a plan, and that is to rebalance (meaning, in this environment, to sell some bonds, alternative assets, and cash, and to buy some stocks). But for now, we’re preparing buy orders while generally holding off on execution. It’s possible that delay will cause us to miss the best buying opportunities, but history tells us odds favor a delay of a few days or weeks.
That said, some opportunities now look compelling, and in certain accounts we’re likely to do some tax loss harvesting and a bit of selective buying before we do general rebalancing. That will depend on current account allocations to those positions relative to target holdings, sector allocations, and asset class allocations for the respective portfolios.
An Important Defensive Move
As we prepare to do significant stock purchases related to rebalancing, we’re also taking a significant step to make portfolios more defensive. Recent research has led us to reassess the risk associated with the interplay between the European sovereign debt crisis and the credit condition of European banks. On average, these banks are both heavily invested in deteriorating credits (the bonds of Greece, Portugal, Ireland, and others) and very dependant on short term financing (much more so than their US counterparts). This is a bad combination and creates a level of risk that we consider not fully discounted.
There is an important distinction between forecasting and analysis. We can’t predict the future, but we must carefully analyze the present. As Howard Marks of Oaktree Capital wrote, “You can’t predict, you can prepare”.
Our analysis of where we stand is that European financials sit on the edge of a precipice. They may or may not fall over. We don’t know. But our conclusion is that those risks are so high now and the margin of safety so thin that we should reduce exposure to portfolio risk. We’re aware that the European financial crisis is a high profile issue, so it’s possible that markets have fully discounted these risks. As we’ve said before, “the snake that bites you is usually not the one you see”. But risk/reward in this particular case is asymmetrical: if this tips the wrong way, consequences are likely severe, whereas, if it muddles through, European stocks should do fine but then so should most other stocks as well.
Domestic banks are not immune to Europe’s woes either mostly because they have sold so much CDS (credit default swap) insurance on European financials. Dodd-Frank financial regulation added significant regulatory burdens, but has done nothing to reduce risk associated with CDS issuance by big US financials (as we’ve noted before).
So, where not constrained by tax implications, we’re taking the following steps to reduce exposure to the European financial crisis:
This week, we swapped most of our Harbor International Fund (HAINX) for Hussman Strategic International Equity Fund (HSIEX). Harbor is a great fund and was generally our largest international stock position, but it has the largest European exposure of any of our widely held international funds (74%). Hussman holds less than 2% in financials (versus more than 20% for HAINX), and at present, its entire portfolio is fully hedged with options. As such, Hussman Strategic International is the developed international markets fund with the least exposure to the European financial crisis of any fund we know. It has no yield and a materially higher annual expense ratio than Harbor, so we’re unlikely to hold Hussman for years, but for now, this swap considerably reduces risk for about a third of our established international exposure on average (of, course, given unique tax implications, we were unable to sell as much Harbor as we would wish for some accounts).
We also swapped one DFA small cap international fund, DFA International Small Cap Value (DISVX), for another, DFA International Small Company (DFISX). DFISX has a 53% allocation to Europe while DISVX has 59%. Much more importantly, the one we are buying has an 11% allocation to financial stocks whereas the one we are selling has a 28.5% exposure to financials. Annual expenses for each are low (0.56% per year for the one we are buying, 0.70% for the one we are selling). This swap is not likely to be just a temporary move. We’re doing this in accounts where applicable and in which tax implications are not prohibitive.
Today, we sold a Deutsche Bank commodity linked structured note. In IRAs, we’re buying a commodity ETF (DBC). In taxable accounts, we’ll be replacing that holding with a commodity mutual fund. The rationale for this trade is that the structured note, while linked to a commodity index, is also in fact a bond issued by Deutsche Bank. We’re not especially concerned with that particular credit, we’re just concerned about the “tarred with the same brush” effect in the event that the European credit crisis escalates significantly. Note that DBC, is a fund managed by Deutsche Bank, but, importantly, is not an obligation of that bank.
Yesterday, we also began selling some domestic bank positions, principally, JP Morgan (where held and where adverse tax implications are not large) and buying a Canadian bank, Bank of Nova Scotia (BNS). We already hold one Canadian Bank widely, Toronto-Dominion, and BNS is for most accounts a second Canadian bank position. As noted above, we’re concerned most of the largest US banks and brokers still have significant exposure to the credit of European financial companies through CDSs written (we don’t know for sure – disclosure is horrible), and the major Canadian banks have materially better loan portfolios. Our work has favored BNS over most US banks for some time, but we were reluctant to put two Canadian banks in portfolios when our benchmark only included US banks, however, now we see that as a likely advantage.