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Most investors have heard the recommendation to rebalance their portfolios. Rebalancing is frequently mentioned to accomplish resetting your current portfolio asset allocations to their desired target allocations. However, as Stock-Net reports, there is also another important benefit to rebalancing.

Rebalancing also has a hidden power: that of the potential to increase your returns over time, when compared to buy-and-hold investing. By, in effect, harvesting volatility, rebalancing forces a ‘buy low, sell high’ process, and then, as assets that were weak recover and assets that were strong weaken over time, the transferring of money back and forth can actually increase overall portfolio returns over time. I found an interesting mathematical article that explores this effect in great detail, you can read all the details here: Rebalancing: Magic Formulas

What can we as investors learn from this? For one thing, the rebalancing bonus can be a significant boost to portfolio gains over time. To achieve the maximum rebalancing bonus, portfolio assets must be uncorrelated. Further, the variation in returns across different assets and asset classes will mean that optimal rebalancing periods could vary significantly. However, with the potential of significant rebalancing bonuses, attempting to find a near-optimal rebalancing period could be very beneficial. For example, Caprock Analytics uses these ideas as part of their portfolio optimization engine, considering diversification, security correlation, asset class correlation, security volatility, and rebalancing periods among other factors while building their customized portfolios.

As an individual investor, you may be satisified with using an approximation of an optimal rebalancing period, and many advisors recommend annual portfolio rebalancing. Whatever rebalancing period you use, with continued usage, you too can benefit from the hidden power of rebalancing.

Facing the drive for ever higher returns, many endowment and pension funds are planning significant changes to their portfolios. Stock-Net has an update on the planned portfolio changes by these big-money funds.

In a recent survey of over 1000 firms, managing over $7 trillion, released by Greenwich Associates, many institutional investors are planning portfolio shifts that increase emphasis in investments like hedge funds and private equity. These moves are coming at the expense of typical mainstream asset classes like US stocks and bonds.

Over the last year, these firms in aggregate reduced their exposure to US stocks by 2%, down to 45%. Increased money was invested in international stocks, hedge funds, private equity, and real estate. Bond allocation changes are generally flat over the last few years.

Potentially more significant, many firms are now giving their managers the ability to short stocks. These changes in aggregate are moving toward riskier investment strategies, and away from the typical US stock and bond investments, requiring a greater degree of sophistication and acceptance of risk.

In terms of individual asset classes, there are some clear shifts underway. Firms are clearly reducing exposure to US stocks, both actively and passively managed. There is also a strong agreement among the firms to increase exposure to equity real estate, private equity and hedge funds.

What can be learned from this? One point is that international investing will be increasingly important, as the world economy continues to expand. Another point is that accepting more risk in investments may not always lead to greater returns. Hedge fund returns, on average, have been declining in recent years, as the total number of hedge funds has exploded, resulting in many firms chasing the same opportunities.

Third, the rush to private equity may be a little late, as private equity firms have benefited greatly from favorable capital markets of the last few years; as capital markets are expected to become more strict, the returns of private equity may be set for a plateau or a decline. A fourth point is that these firms are increasing the diversification of their assets, as they move money from US equities to international, real estate, and hedge fund investments. In aggregate, these could be very profitable moves over the coming months and years.

Model asset allocations from prominent financial advisers allow us to compare their recommendations, and to analyze the differences. Stock-Net analyzes the current recommendations of Litman/Gregory and compares them with recommendations from Caprock Analytics.

Litman/Gregory’s analysis has concluded that large-cap stocks are likely to do well over the next three to five years. Their moderate-risk model allocation now heavily emphasizes large-caps, to the tune of 60%. The remainder of the allocation includes: High quality bonds 17%, international stocks 15%, emerging market bonds 5% and commodity futures 3%. The positions are implemented with 11 no-load mutual funds.

The rationale for the Litman/Gregory allocation starts with their belief in the strong future performance of large cap stocks. Bonds are added to reduce volatility, and international stocks are there for diversification and return enhancement over time. Litman/Gregory adds emerging market bonds as a hedge against a US dollar decline. Finally, the commodity futures allocation is included because of strong data indicating the diversification value of this asset class. Their current asset allocation removed any exposure to the real estate asset class since 2004. This moderate risk strategy has returned an average of 9% annually over the past five years.

Compare this with the moderate allocation recommendations of Caprock Analytics. The Caprock moderate allocation portfolio involves active asset re-allocation, targeting a broad array of asset classes for diversification. The Caprock allocation includes 10% exposures in real estate, energy stocks, international value, and commodities, along with US equity exposure. Caprock Analytics optimizes portfolios by using proprietary analytical techniques, with the goal of safely maximizing returns while maintaining a broad level of diversification and risk management. The analytically-constructed Caprock portfolio recommends ETF’s to cover these asset classes. While the portfolio allocations change over time and can involve frequent trading, their moderate portfolio approach has produced returns of 31% annualized over the past three years with volatility roughly equal to the S&P500.

What can we learn from these two significantly different portfolios, both aimed at moderately aggressive investors? One point is to understand the rationale behind the allocations, to see if your investing objectives are aligned with the objectives of the portfolio. Another point is that you should ensure that your portfolio is adequately diversified. The 60% allocation to large-cap US stocks in the Litman/Gregory portfolio is a very strong emphasis in large cap stocks, while the Caprock portfolio allocates between 10 and 20% to large cap stocks. In general, dramatically over-sized bets on any particular asset class may not be a good approach, generally leading to poorer diversification and a corresponding increase in risk. As an informed investor, a good approach is to do your homework, understand the proposed investment objectives and how they compare with your personal objectives, ensure adequate diversification and choose a suitable level of portfolio risk. Once you take care of these, you should be in store for many happy returns.

Many retirees or near-retirees come to the point where their portfolios asset allocation decisions are crucial and can help ensure having a comfortable amount for retirement and maintaining an adequate income level during retirement. Stock-Net has reviewed some asset allocation alternatives in earlier posts. Many investors may start out by managing their own portfolios, but may at some point want to seek professional portfolio management.

However, the cost of professional guidance can be quite steep, averaging between 1% and 2% of assets per year. For a 1 Million dollar portfolio, a 1.5% annual fee drains $15,000 per year from your account. Considering this cost, can portfolio management be safely done by an individual investor? If so, the cost savings could be substantial.

Studies have shown that to maximize portfolio survival while receiving income from the portfolio, a proper range of equities must be maintained, typically between 40 and 70%. Modern Portfolio Theory indicates that a portfolio diversified among asset classes like bonds, real estate, international securities, small cap stocks, and large cap stocks will generate the greatest return for a manageable level of volatility. The list of asset classes that can be used to construct a portfolio can become quite long and there are endless debates about the proper methods for asset allocation.

The general idea is that by mixing asset classes that are uncorrelated (one zigs while the other zags), you can maximize long term return while minimizing short term fluctuations in portfolio value. By finding the level of risk (volatility) that you are comfortable with, you can then seek to maximize your portfolio return while keeping the risk at the desired level. Exactly how to do this can become quite complex, however there are numerous resources available to support further investigation. One of my favorite books in this area is William Bernstein’s “The Intelligent Asset Allocator”.

Another alternative would be to subscribe to one of the new services that are becoming available that provide up-to-date model portfolios targeted to various risk levels. You can choose the portfolio that is right for your situation, then track its allocation recommendations with your portfolio, ensuring that you maintain adequate diversification and stay in your risk comfort zone. As an example, you can read about the approach of Caprock Analytics on their website. They offer several levels of portfolios, constructed of low-cost ETF’s, giving you full, low-cost diversification. Additionally, a portfolio subscription from Caprock Analytics would cost about $1,000 per year, a big improvement when compared to the $15,000 fee in the example given above. In our example, using a service like the Caprock Analytics service lowers the annual fees for accessing professionally constructed portfolios from 1.5% per year down to 0.1% per year, a very significant cost reduction.

Wealthy investors have long had access to high-end optimized portfolio management via financial advisors, separately managed accounts, or brokers dedicated to high net worth individuals. Fees for these services vary, but typically are based on annual fees against a percentage of your account size, usually around1% – 2% yearly.

Now, services are becoming available that offer access to advanced, highly optimized portfolios for fees that are more affordable for middle-class investors. An example of this type of service is Caprock Analytics. This company uses advanced portfolio optimization algorithms, publishing updates to a range of portfolios for subscribers. Their fees seem competitive for investors with capital to invest of $50,000 or more.

The only catch is that you must execute all trades and maintain control over your own account, subscribing to a service and tracking a portfolio of your choice. By doing it yourself with the guide of these professionally optimized portfolios, your savings could be substantial.

Caprock Analytics produces a range of portfolios, so you should be able to find portfolios that match your desired comfort level of risk. The “Caprock Analytics Conservative” portfolio sports some rather amazing returns, while demonstrating a very smooth equity curve, indicating a very good return for a low level of volatility. If these types of returns continue, it could be a very profitable choice to subscribe and track some of the Caprock portfolios.