August 2010
How rebalancing helps reduce risk and improve performance
“Run your winners, cut your losers” “Buy when others are fearful, sell when others are greedy”. Two of the best known stock market aphorisms directly contradict each other. How can the rational investor manage a portfolio that accommodates both positions? They can’t of course which is why they, and most stock market clichés are worse than useless.
There is though a very real issue behind both phrases and that is stock selection is actually less important than stock weight for determining portfolio returns. After all, not holding a stock is simply a zero weight. Owning a stock that doubles in a year doesn’t do much for a fund if it only has half a percent invested in it. On the other hand putting 5% into a micro cap stock is a big risk and it also may create liquidity problems. Even more important than the initial exposure though are changes in weighting as stocks rise and fall relative to the index and other holdings. Investors need to know how fund managers deal with this problem to understand exactly how a fund is run.
This issue was thrown into the forefront of investors minds in the second quarter of 2010 after the Deepwater Horizon rig drilling the MC 252 well exploded and caught fire on 21st April and then subsequently sank. The scale and cost of this disaster precipitated a massive fall in the share price of BP, the operator and 65% owner of the well. At the time the disaster struck BP shares were trading at 642p. By the end of June they had dipped below 300p. Over that period BP’s weight in the FTSE 350 index fell from about 7.1% to 4.6% and created a huge change in the shape of portfolios for investors.
The way managers responded to that event gives a good indication of whether their actions added or subtracted value. Some money managers used the opportunity to buy more shares but soon found the experience increasingly painful as the stock continued to fall. Exactly who sold remains unknown but it is hard to imagine that US investors were proud of seeing that holding on their statements for the end of June going out to clients. Is it just coincidence that the nadir of the share price was reached three business days before the end of the month?
Conventional capitalisation weighted index funds simply followed the stock down and then back up. New investors in such index funds, depending on when they dealt, could have been investing anywhere from 4.6% to 7.1% of their portfolio into BP.
Active managers, on the other hand, would have determined earlier whether to be underweight or overweight in BP. That would have a major impact on their relative performance, at least initially. Overweight investors would have been hurt relatively more badly than those underweight the index. However, as the stock fell, and assuming active funds did not top up and buy more, the portfolio impact would have diminished as BP’s weight in the index and portfolios shrank. So called active funds that did nothing would, in contrast, experience progressively less pain as the holding shrank. A 1% fall on a 5% holding is much less painful than a 1% fall on a 9% stake.
Then, in July, sentiment turned and BP rose dramatically from 300p to 400p.
All funds now benefited from a double whammy. Not only was BP going up but its size in the portfolio was increasing. A 1% move on a holding of 3% is very nice, but not as good as 1% move on a 4% stake and nothing like as good as when it gets to 6, 7 or 8%.
This feature of an expanding balloon growing rapidly is at the heart of stock market volatility and is easily compounded by additional buying into a rising market. In a small way this experience describes exactly how stock market bubbles are formed. A process, incidentally, that is exacerbated by conventional index trackers. Everyone loves this stage. It is the next stage, when the bubble bursts and investors frantically dump positions that have become far too large, that the risks of this approach become apparent.
The only way the volatility caused by index trackers and what might be called lazy active managers can be beneficially exploited is to use a process that determines the size of a holding by some measure other than price. Using a different reference point it is then possible to continually rebalance the holding back towards the desired weight whatever the market does. In other words the fund trades to maintain the holding of the stock at a certain predetermined level. And this is exactly what a fundamental tracker does.
The way it works in practice is best illustrated by the actions taken during the BP crisis.
Having been a buyer of BP all the way down to 306p to maintain a 9.5% weight The Munro Fund increased the number of shares it held in BP by over 50%. Once the market turned though it rapidly found itself overweight in the stock and it was a steady seller into a rising share price. Stock bought for 306p was sold for 322p, that bought for 334p on the way down was sold 343p on the way up. In this way a passive fund exploited volatility in the market to add value. Over the period from early May to mid July the fund increased its net holding in BP shares by 32% in addition to the additional value added by trading shares on the way down and back up again. That additional holding was secured at a weighted average cost of about 399p.
It might seem odd that a tracker fund should trade so actively. But the concept is to take advantage of market volatility and use that to benefit a fund that knows exactly what it wants to hold. The alternative is to let the market determine your weighting. How much value does that add? The appellation of “active tracker” might seem oxymoronic. But once you get away from the dogma that the “price is always right” there is plenty of scope to add value.