Politics & Policy

When Rebalancing Comes Marching In

A popular investment strategy might be causing some bad vibrations.

The investment approach known as lifestyle, or lifecycle, investing has gained an enormous number of proponents in recent years. Full-page ads in newspapers and investment publications tout the use of this methodology for retirement-plan investors — and it appears to be a logical approach to both long- and short-term retirement planning.

But the problem is that this approach has become so popular, it may one day (if it’s not already) impact market volatility.

These plans are popular for a reason: They make strategic sense. In short, the “weightings” of assets in each lifestyle portfolio are determined by the risk characteristics of classes of investors. So, if you are not going to be in the market for that long, your portfolio risk will be adjusted low. But if you have a long investment horizon, your risk will be notched higher, which traditionally will give you a better return.

Promoters of lifestyle investing have emphasized the use of “rebalancing” to add value to the asset-allocation process. Rebalancing takes asset classes in a portfolio back to target weightings after both up and down market movements that result in a rise or fall in the relative weightings of asset classes. For example, let’s say a portfolio is weighted 50 percent bonds and 50 percent stocks at the beginning of a measurement period (say one quarter). If stocks rise and shift the weighting to 40 percent bonds and 60 percent stocks, the portfolio will be rebalanced back to the 50/50 mix as specified in the original asset allocation at the end of the measurement period.

As rebalancing strategies have gained adherents in the realms of mutual funds and retirement plans, concerns have grown as to the impact of the purchase and sale of stocks at the beginning of each quarter as a result of rebalancing. It’s like soldiers marching in cadence over a small bridge. When the number of troops grows sufficiently large, the cadence in their steps triggers a systematic action that causes the bridge to vibrate to a point where it could collapse. Similarly, the growing use of rebalancing could impact market volatility.

Over the past few years, the stock market, after a strong quarter, declined in the first few weeks of the following quarter, quite possibly due to the impact of rebalancing where stocks were being sold to justify getting back to a target asset mix. There have been periods when stocks surged early in a new quarter after a major quarterly decline. And in 2005, the vibrations became larger.

After the strong fourth quarter of 2004 (the S&P 500 rose 9.23 percent), the stock market declined 2.26 percent in the first two weeks of 2005 — even though market pundits saw a strong year for stocks. By January 24, when all of the rebalancing was just about over, the market had declined a total of 3.97 percent. Again, in the fourth quarter of 2005, the market dropped 4.23 percent in the two weeks following a moderate third-quarter S&P 500 advance of 3.6 percent. Another example of this relationship was reflected in the volatility of smaller stocks. The Russell 2000 was up 8.39 percent for the third quarter of 2005. In the ensuing two weeks, the Russell 2000 declined 5.23 percent!

These few observations do not make a trend. More, there are examples of this rebalancing-effect not showing up in the recent past. Yet, with the growing implementation of rebalancing, even lesser rallies could have a significant impact on stock prices in those first few weeks of a New Year because annual rebalancing is even greater than quarterly rebalancing.

At the beginning of 2006, the market dodged the rebalancing event that might have triggered market volatility. For the fourth quarter of 2005, the benchmark S&P 500 rose only 2.8 percent while the Lehman Brothers Aggregate Bond Index also rose in price — by 0.59 percent, not a sufficient fluctuation to trigger volatility from a quarterly rebalancing. Similarly, for the year as a whole, the S&P 500 rose 4.91 percent while the Lehman Brothers Aggregate Bond Index rose 2.43 percent, still not a significant difference to trigger the volatility induced by institutional firms attempting to adjust for the market impact on portfolio weightings.

For more aggressive investors who accept the reasonableness of this hypothesis, and a few who run hedge funds, there may be an opportunity to capitalize on this market inefficiency before the rest of the world catches on — just like the January effect and the Dogs of the Dow. But for everyone else, if we have a strong first quarter in stocks and a weak one in bonds — or vice versa — keep your eye on market volatility in early April, a period that could again reflect the impact of rebalancing. Rather than a hypothesis, this might be a real trend — and one worth watching.

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.


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