Something I'm thinking about

[pb4uski]

We all know about the benefits of rebalancing and that it prods you to sell high and buy low. The other day, I was thinking whether this benefit could be used to optimize returns and minimize risk in my domestic equity portfolio (which is currently mostly a domestic total stock index fund).

The idea would be to each year rebalance the S&P 500 sectors to a target allocation. Since the proportions of the S&P 500 sectors are not fixed and vary over time, the targets would probably be based on a 3 or 5 year average of the sectors to the total. Alternatively, the targets could be based on equal weighting of the sectors, which some believe is better than the market cap weighting implicit in the S&P 500 index.

Also, from some of my reading it seems that sectors is an area where some believe that managed funds can consistently better index funds so I think I would use Fidelity sector funds rather than Vanguard’s indexed sector funds.

I backtested the strategy from 2005 to 2012 (because annual return data for the sector funds was readily available) and it seems to be significantly better than just investing in the S&P 500 or the Total Stock Market Index Fund for those years. See table below.

I would probably need to bifurcate my domestic equity allocation (currently ~45% of my AA) to domestic large cap and domestic mid/small cap and would use this strategy for the domestic large cap allocation (which would be about 30% of my total AA) and use the mid and small cap index funds to round out the domestic equity portfolio.

Any thoughts?

	2005-2012	2005	2006	2007	2008	2009	2010	2011	2012	Value of 10,000
S&P 500	4.2%	4.9%	15.8%	5.5%	-37.0%	26.6%	15.1%	2.1%	16.0%	13,915
Total Stock Market Index Fund Admiral	4.8%	6.1%	15.6%	5.6%	-37.0%	28.8%	17.3%	1.1%	16.4%	14,501
Average Weighting
Indexed Sector Strategy	5.6%	7.3%	16.2%	7.3%	-36.6%	30.7%	17.7%	1.3%	16.6%	15,418
Managed Sector Strategy	6.6%	12.3%	14.6%	12.4%	-41.5%	43.9%	20.5%	-3.9%	18.5%	16,706
Equal Weighting
Indexed Sector Strategy	6.2%	8.1%	17.9%	10.3%	-36.2%	30.1%	17.8%	2.1%	15.2%	16,177
Managed Sector Strategy	7.3%	13.1%	16.7%	15.1%	-41.6%	43.8%	20.4%	-2.4%	17.3%	17,591

 

[eytonxav]

Interesting! Can you explain a little more how you would select and rotate sectors going forward?

 

[Animorph]

I'm a slice-and-dice investor. I think anytime you can divide a large group into multiple pieces and rebalance them you can gain something. I think it's fairly clear that choosing pieces with the highest volatility (maybe not daily, but something like monthly that gives you a chance to rebalance) will give you the best rebalancing opportunities. I think equal values in your partitions will also give you a better rebalancing size. Rebalancing a 5% piece against a 30% piece fully utilizes the 5% piece, but not the 30% piece.

So, are sectors more volatile, or do they have higher peaks and lower troughs, than growth/value/large/small? That seemed likely to me, but I was already set up with the traditional splits. I haven't seen any articles proposing this, so I don't have any numbers.

And second, can you divide the group into relatively equal value pieces that still have that high volatility? An equal weighting should give you that. That's pretty much what I use for the standard splits.

I think your plan would be interesting.

 

[pb4uski]

Interesting! Can you explain a little more how you would select and rotate sectors going forward?

Since the backcast relies on calendar year return data, it would be analogous to rebalancing on January 1st of each year but in reality rebalancing could be done on any date one choses.

Below is the table of the weightings that I used in the backcasting analysis. The market cap weightings were rounded from eyeballing some historical graphs that I found - see http://www.bespokeinvest.com/thinkbig/2012/1/17/sp-500-historical-sector-weightings.htmlif - if I were to do this for real I would probably look to the actual sector weightings for the last 3 or 5 years on my rebalance date and take an average.

	Equal	Mkt Cap
Consumer Discretionary	10%	12%
Consumer Staples	10%	11%
Energy	10%	9%
Financials	10%	15%
Health Care	10%	12%
Industrials	10%	12%
Information Technology	10%	15%
Materials	10%	4%
Telecommunication Services	10%	6%
Utilities	10%	4%
	100%	100%

 

[photoguy]

Have you done a literature search?

I'm pretty sure this has been tried and studied. The fact that I hear very little about such models makes me think it wasn't successful and that it doesn't have the support anywhere near like the FF models

 

[mathjak107]

when i was going to utilize the bucket system i was thinking along those lines since typically buckets are rebalanced by years of spending money and not performance .

i was thinking of rebalancing in the stock bucket only and setting target allocations.

when i really thought about the big picture though it was just adding another layer of something to either go wrong or right and i decided with a 50/50 chance of it doing anthing positive i killed the idea.

 

[MichaelB]

Why not invest in an equal weighted S&P fund instead of doing all the rebalancing by industry?

 

[pb4uski]

Have you done a literature search?

I'm pretty sure this has been tried and studied. The fact that I hear very little about such models makes me think it wasn't successful and that it doesn't have the support anywhere near like the FF models

Yes. I have found a fair amount on equal weighting vs market cap weighting, but nothing on rebalancing annually. If anyone knows of something, I would be keen to read it.

 

[pb4uski]

Why not invest in an equal weighted S&P fund instead of doing all the rebalancing by industry?

The equal weighting S&P funds that I have seen had ERs that were higher than what I would have using sector funds or ETFs given the relatively modest effort to rebalance (I'm thinking a few hours a year). Also, if I decide to go with managed sector funds rather than index sector funds, there is no pre-made version.

Also, as I understand it the equal weight indices equally weight the individual stocks in the index, so in the S&P 500, each stock is 1/500th (.2% ot the total) whereas if I went with equal weighting I would equally weight the sectors. BTW, I'm not convinced at this point that equally weighting the sectors is a good idea.

 

[Midpack]

Very interesting, I'm heading out but I hope to come back and play with this idea myself. I am sure you found this along with lots of other info To Beat the S&P 500, Try the Other S&P 500 - SmartMoney.com

Like photoguy, I wonder why there aren't more MFs/ETFs like your proposing since rebalancing is pretty straightforward, so low ERs should be possible. I found one from Guggenheim?

 

[hlfo718]

There is a sector rotating etf from Powershares, I think. keep in mind if you do this you will probably have to pay comm plus any taxes, unless is tax def account with free trades. Besides, why make it more complicated than it is? Simple and easy wins long term.

 

[gerntz]

We all know about the benefits of rebalancing

This article questions if we do know:

Evanson Asset Management - Rebalancing

 

[Lsbcal]

...(snip)...
I backtested the strategy from 2005 to 2012 (because annual return data for the sector funds was readily available) and it seems to be significantly better than just investing in the S&P 500 or the Total Stock Market Index Fund for those years. See table below.

I would probably need to bifurcate my domestic equity allocation (currently ~45% of my AA) to domestic large cap and domestic mid/small cap and would use this strategy for the domestic large cap allocation (which would be about 30% of my total AA) and use the mid and small cap index funds to round out the domestic equity portfolio.

Any thoughts? ...

Looking at your table, it makes me wonder if part of the outperformance is due to a larger dose of small/midcaps in those sector results. We know that Total Stock Mkt is only 70/20/10 large/mid/small. For 2005-2012 the MSCI categories showed these CAGR's:

LV = 3.7%
LG = 5.4%
MV = 5.7%
MG = 6.1%
SV = 5.1%
SG = 7.0%

Just a thought.

 

[ERD50]

We all know about the benefits of rebalancing
...

This article questions if we do know:

Evanson Asset Management - Rebalancing

Thanks gerntz, for that link. An excerpt:

"Over the entire 82-year sample, it is clear that the rebalanced portfolio had no significant advantage over the portfolios rebalanced less frequently", and "..trying to predict which strategy will have the highest returns going forward will likely lead one down a path of unproductive data mining", and "Aside from avoiding excessive trading, there are no optimal rebalancing rules that will yield the highest returns on all portfolios and in every period."

I was going to question the conventional wisdom in re-balancing also, but I didn't have any good sources.

A few years back I made a somewhat crude model of this, and while not conclusive, it did point out something that I thought could be counter-productive. The problem I saw is that in a rising market, you are re-balancing out of the sector that is rising. For example, if that sector increases 5% for 3-4 years, you keep rotating out of it, and miss much of that rise. It's offset on the other side of course. But my model showed that they tended to pretty much cancel out, similar to these findings. It also makes sense just thinking about it, but tough to say w/o really running the numbers.

heheh - another FIRECALC option that would be interesting (and answer the question of "What do you do all day?" for some of us) - no re-balancing?

I still favor re-balancing, but I'm not a slave to it (generally just too lazy, and too conflicted about whether the move is the right thing at the right time). I think it helps to have some kind of guide-lines, and since most people do have some kind of risk tolerance aligned with an AA, I think some re-balancing can help us get a handle on all the variables. It's something that we can control. It may just be an illusion, but not a harmful one, IMO.

-ERD50

 

[pb4uski]

This article questions if we do know:

Evanson Asset Management - Rebalancing

So if I understand the article correctly, it is suggesting that rebalancing between asset classes is beneficial, but that rebalancing between different classes within equities is not.

I do note that the studies looked at equity classes (large/mid/small cap and value/growth and combinations thereof) rather than sectors so it is interesting but not totally on point. The key question would be whether sectors are as correlated as equity asset classes seem to be.

Since the size of sectors comprising the S&P index change significantly over time, I think that suggests that sectors are not very correlated.

 

[pb4uski]

Looking at your table, it makes me wonder if part of the outperformance is due to a larger dose of small/midcaps in those sector results. We know that Total Stock Mkt is only 70/20/10 large/mid/small. For 2005-2012 the MSCI categories showed these CAGR's:

LV = 3.7%
LG = 5.4%
MV = 5.7%
MG = 6.1%
SV = 5.1%
SG = 7.0%

Just a thought.

I don't think so because the sectors are sectors of the S&P 500 index so they are all just large caps, and do not include any mid/small caps. I think your observation does explain the generally higher returns of the Total Stock Market Index compared to the S&P 500 though (first two rows).

 

[Lsbcal]

I don't think so because the sectors are sectors of the S&P 500 index so they are all just large caps, and do not include any mid/small caps. I think your observation does explain the generally higher returns of the Total Stock Market Index compared to the S&P 500 though (first two rows).

OK, makes sense.

Just for fun, when I looked briefly at the sector ETF's from Vanguard they had a lot of midcap and smallcap exposure. For instance, VG Consumer Discretionary is about 56/25/9 large/mid/small with a bias towards growth: http://portfolios.morningstar.com/fund/summary?t=VCR®ion=USA&culture=en-us

 

[pb4uski]

Very interesting, I'm heading out but I hope to come back and play with this idea myself. I am sure you found this along with lots of other info To Beat the S&P 500, Try the Other S&P 500 - SmartMoney.com

Like photoguy, I wonder why there aren't more MFs/ETFs like your proposing since rebalancing is pretty straightforward, so low ERs should be possible. I found one from Guggenheim?

I looked at the Guggenheim products. What they do is equally weight companies within a specific S&P 500 sector and the ERs are about 50 bps.

 

[pb4uski]

OK, makes sense.

Just for fun, when I looked briefly at the sector ETF's from Vanguard they had a lot of midcap and smallcap exposure. For instance, VG Consumer Discretionary is about 56/25/9 large/mid/small with a bias towards growth: http://portfolios.morningstar.com/fund/summary?t=VCR®ion=USA&culture=en-us

You are so right. I downloaded the prospectus and noticed that the Vanguard sector funds relate to a broader index than the S&P 500 (teach me to read the fine print). While their defined sectors align with the S&P 500 sectors (and I assumed they were indices of the S&P 500 sectors given Vanguard's largeness in the S&P 500 index fund) they are actually broader and cover large/mid/small caps of the defined sectors.

Here is the description for the Consumer Discretionary sector fund:

The Fund employs an indexing investment approach designed to track the performance of the MSCI US Investable Market Index (IMI)/Consumer Discretionary 25/50, an index made up of stocks of large, mid-size, and small U.S. companies within the consumer discretionary sector, as classified under the Global Industry Classification Standard (GICS).

In a way this might be better in that I would not have to bifurcate my total domestic equity portfolio between large (sectors), mid (index) and small (index) as I was thinking I would have to which was going to be a major PITA. Thanks!

Also, since the VG sectors fund cover all capitalization sizes, I think the more relevant comparison in the chart in the OP would be to the Total Stock Line rather than the S&P 500 line.

 

[photoguy]

Here's what I found going through one of my books (Swedroe, 2006, The Successful Investor Today)

Professors Eugene F. Fama and Kenneth R. French demonstrated that it was the exposure to the risk factors of size and value that determined over 90 percent of the risk and reward of a portfolio, not stock selection, sector selection, or market timing. It is important for investors to understand the importance of this finding: Stocks with the same market cap and BtM have the same risk and expected return. This is why there should be no expected compensation for
owning one large-growth stock instead of another. Another issue of importance is that since the exposure to a sector (e.g., technology or health care) is not the major determinant of risk and reward, then investors in sector funds are taking uncompensated risk, risk that can be diversified away.

In other words, when Fama French created their regression models, they tried using sector as a variable and found that it was not predictive or causal in any meaningful way. Under this interpretation, any gains you might get could be explained by the way the sectors load on the different size/value factors.

Sorry I don't have links to any of the original papers where they might have shown their analyses.

 

[lark_L]

I sort of did this for years in my 401(k), although not by sectors. I had four equity funds (Intl, large cap, small cap, growth) and when I rebalanced, I also rebalanced these four back to equal parts of the equity slice. I never tested or back-tested it to see how much difference it made, but I felt like it helped.

 

[nun]

Sounds like a DFA approach.