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Using Last Year’s Results Assuming perfect luck, median luck or worst-case luck in the selection of each year’s sole investment is theoretically interesting, but not very practical. An active portfolio management protocol that uses the performance results of each index from the previous year is more feasible. In other words, an active investor’s choice of index in which to invest for the coming year could be based upon the performance of all possible investment assets (in this case, seven indexes) during the prior year. Performance of indexes (or any investment asset) in the previous year is information that is available to all investors at the beginning of each new year. As shown in Figure 2, an active investing strategy based on “momentum” generated a 13.92 percent annualized return over the 39-year period. This active strategy consisted of reallocating all investment dollars into the previous year’s best-performing index. For example, the best-performing index in 1970 was bonds. Thus, at the start of the next year (1971), all money was shifted into the bond index based on its performance in the prior year. By the end of 1971, the EAFE Index was the best-performing asset; thus at the start of 1972, all money was shifted into the EAFE Index. This pattern was continued through 2008. This active investing protocol does not rely upon luck. Rather, it utilizes the known performance from the prior year to make each new year’s investment decision. Another active investment approach selected the middleperforming asset from the prior year. This is casually referred to as a “mean regression” approach, but may or may not reflect regression-to-the-mean behavior. This particular active investing protocol produced an annualized return of 9.85 percent, which was considerably lower than the momentum strategy over this particular 39-year period. Lastly, an active protocol that selected last year’s worst-performing asset produced a 39-year annualized return of 8.47 percent. Active Vs. Passive Portfolios Each of these three “last year results” approaches utilized only one of the seven indexes each year as the sole investment. This represents very concentrated investing. Far more common is the use of several different indexes (i.e., investment assets) in a portfolio, whether passively or actively managed. In recognition of this, Figure 2 also presents the performance of three actively managed multi-index portfolios: a 40/60 portfolio, a 60/40 portfolio and an equal-weighted seven-index portfolio. The buy-and-hold performance of each multi-index portfolio was previously presented in Figure 1. The “active” portfolio management protocol being introduced at this point is very straightforward: systematic annual rebalancing. The simple act of rebalancing each multi-index portfolio at the start of each year to bring each portfolio component back to its original allocation produced notable improvements in performance. The 40/60 portfolio improved from 8.74 percent using buy-and-hold to 9.07 percent using active rebalancing—which increased the ending account balance by over $32,000. Importantly, the actively rebalanced 40/60 portfolio had 20 percent less volatility in the annual returns (as measured by standard deviation). More return with less risk. The actively rebalanced 60/40 portfolio had a 34 bps higher annualized return compared to the buy-and-hold 60/40 portfolio and a standard deviation of annual returns that was 12 percent lower. Finally, the annually rebalanced equal-weighted sevenindex portfolio produced a 39-year annualized return of 10.21 percent, 84 bps higher than the buy-and-hold sevenindex portfolio. The volatility of annual returns was nearly 40 percent lower in the actively rebalanced seven-index portfolio. Perhaps most compelling is an ending account balance that was nearly $114,000 higher in the actively rebalanced seven-index portfolio. Active Benefits There is another benefit when “actively” rebalancing “passive” indexes. As shown in Figure 3, the ending account balances in bonds and cash in the actively rebalanced seven-index portfolio were considerably higher than the bond and cash ending balances in the buy-and-hold multi-index portfolio (before the final rebalance at the end of 2008). Why does this matter? Bonds and cash have lower returns than equity and equitylike assets over long time frames and, as a result, will not be able to keep pace with the other portfolio continued on page 55 Figure 3 Total Ending Balances In Actively Rebalanced And Buy-And-Hold 7-Asset Portfolio (39-Year Period From Jan. 1, 1970 To Dec. 31, 2008) $1,428 Starting Balance in each of the 7 Indexes Large U.S. Stock Small U.S. Stock Non-U.S. Stock U.S. Bonds Cash REIT Commodities Total Ending Portfolio Value (Growth of $10,000) Actively Rebalanced 7-Index Portfolio* 54,461 57,236 48,946 95,462 87,751 52,559 46,257 442,671 Buy-and-Hold 7-Index Portfolio 48,784 64,118 40,716 30,090 14,748 73,296 57,117 328,868 Source: Author calculations using Morningstar. *Account balances before rebalancing at the end of 2008 www.journalofindexes.com January/February 2010 45
Apparent Value Added By Fund Management This element is the approximate value that appears to be added to the fund by the portfolio management process. Analysts eventually will be able to break down the performance contribution of active managers in a variety of ways. For example, with clean data it is possible to calculate the value added by the transactions the fund manager has made to change the composition of the portfolio during a quarter or a year, or to compare the beginning of the period portfolio’s performance with the performance of an index. There is scope for ingenuity in analyzing an active manager’s ability to add value or highlight aspects of the investment process that have worked less well. As the availability of fund data from SEC filings improves, analyses of transaction costs and value added by a fund’s investment process will become more sophisticated. For example, the value added by fund management will be broken down into a number of distinct components and a noise element. The total apparent value added is a residual in the example in Figure 2. When we subtract the net tracking error (-1.88 percent) from the total of the cost elements in the left column (-2.65 percent), we get a total for the positive elements of (+0.77 percent). Adding the market timing loss (-0.02 percent), we get an apparent value-added residual of (+0.79 percent) for the fund manager’s efforts. What Is The Significance Of Figure 2? Figure 2 is simply an illustration of the kind of fund performance breakdown that is theoretically possible today and will ultimately be routine. To the extent that tracking error is measured relative to a reasonable benchmark, the costs incurred by the average fund will cause the net tracking error to be negative. The breakdown into cost and performance elements and comparisons to other funds and other managers will enhance the fund selection process. A fund analyst’s ability to perform this kind of analysis—and even more detailed breakdowns—depends on the fund industry’s adoption of a new data standard: XBRL. I will cover XBRL in depth in the next and final installment, to be published in the March/April issue of the Journal of Indexes. Endnotes 1 Gastineau, Gary L., and Kritzman, Mark, “The Dictionary of Financial Risk Management,” Frank J. Fabozzi Associates (now a division of John Wiley & Sons, Hoboken, New Jersey), 1999. See pp. 283-284. 2 In addition to the indexes for the Sector SPDRs, the Nasdaq 100 capitalization weightings are modified to make it RIC compliant. The price-weighted Dow Jones Industrial Average is usually RIC compliant without modification, but it dropped out of compliance at the end of March 2009. 3 The constraints will be relatively tight for an index fund, but they should not discourage an index fund manager from trading away from the implementation time of an index change. In many large index funds, avoiding the official index implementation trading frenzy is akin to an opportunity to pick up money from the sidewalk. 4 Israelsen, Craig L. and Gary F. Cogswell, “The Error of Tracking Error,” Journal of Asset Management, March 2007, vol. 7, No. 6, pp. 419-424 appropriately argues that the magnitude of tracking error (standard deviation version) is not a suitable performance indicator for active managers. I agree, and I use tracking error (performance difference version) only as an organizing framework. 5 The most popular measure is prior period performance. 6 See Edelen, Roger M., Richard Evans and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” unpublished working paper, March 17, 2007. 7 A fund that combines small foreign holdings with a largely domestic U.S. portfolio may have an adverse tax effect for some of its shareholders that can be avoided by a fund that holds predominantly non-U.S. securities. Global funds with predominantly U.S. holdings are often tax inefficient for U.S. investors. Israelsen continued from page 45 components (in terms of dollar account value). Accordingly, the account balances will become disproportional over time (as demonstrated in Figure 3). The equity and equitylike portfolio components (REITs and commodities) will tend to dominate the portfolio. This can be advantageous if, in the latter years of a portfolio, the equity-based assets perform well. But, if equity and equitylike assets suffer declines, the investor can experience heavy losses because of his disproportionately large allocations in equity. This potential portfolio imbalance can be solved by the active strategy of rebalancing. When equity assets have strong annual gains, their excesses are diverted (i.e., rebalanced) to the fixed-income components of the portfolio (bonds and cash). Because bonds and cash seldom have negative returns, the gains are preserved in a fixed-income “lockbox.” As investors age, the notion of a lockbox becomes very appealing. During equity market downturns (i.e., 2008), the bond and cash portfolio components—which have been systematically replenished through active rebalancing—will have sufficient reserves to provide needed liquidity. Summary The upper limit (or maximum parameter) of active-passive investing is an annualized return of 30 to 34 percent. This requires perfect luck or perfect foresight, neither of which represents a defensible tactical active strategy. By contrast, a portfolio with a randomly selected index at the beginning of each year generated a 9.05 percent annualized return over the 39-year period from 1970-2008. This type of random active-passive portfolio represents a more logical performance threshold against which actively managed funds should be measured. Rebalancing a multi-index passive portfolio represents an “actively passive” portfolio that outperforms a passive-passive multi-index portfolio. Rebalancing represents a potent active strategy that seldom receives the attention it deserves. Rebalancing is often simply assumed to be a good idea. This research has quantitatively demonstrated just how good it is. More importantly, rebalancing is an active strategy that passive investors can probably live with. Most passive investors may recognize that they are, in fact, actively passive. www.journalofindexes.com January/February 2010 55
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