Investing: Getting the Balance Right

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Based on the elevated market volatility of the past two years, Palisades Hudson Asset Management decided earlier this year that it needed to take a serious look at how frequently it needs to rebalance its customized client portfolios.

"We used to rebalance as needed, which for a volatile year meant a handful of times, and for a more middling year meant once or twice," says Jonathan Bergman, the firm's chief investment officer.

Palisades Hudson decided to allow the weights of its asset classes to fluctuate 10%, relative to their weight, off their target. For a simple portfolio split 50/50 between stocks and bonds, the weight of stocks would be permitted to rise as far as 55% before Palisades would sell shares and decline to 45% before it would buy shares. For a balanced portfolio, the firm rebalanced four times in 2008 and twice this year. That includes harvesting tax losses on securities that have declined in value. Bergman says he wrings out tax losses as often as he can and those losses carry forward indefinitely.

Average Allocation

One basic tool that investors who want to take a simpler approach can use to guide rebalancing decisions is a barometer of market sentiment among professionals such as the weekly survey of National Association of Active Investment Managers (NAAIM). A study released in November by Hepburn Capital Management showed that rebalancing based on professional money managers' allocation approaches reduces risk by half while boosting returns.

Hepburn backtested three years' worth of data from the weekly allocation surveys of 115 participating member firms of NAAIM. Calculating the average asset allocation among the surveyed managers for the prior 13-week period, he would use that as the allocation for the following quarter. The fact that the S&P 500 index had six positive quarters and six negative quarters within those three years gave the effect of a full market cycle, which was ideal for testing purposes, says Will Hepburn, president of Hepburn Capital Management.

Nominal returns, which aren't adjusted for inflation or taxes, increased from a three-year loss of –0.56% for the 60/40 stock/bond mix to a 9.06% gain using what Hepburn calls adaptive rebalancing over the period from Sept. 30, 2006, to Sept. 30, 2009. The average exposure to stocks among NAAIM members began to fall starting in the second quarter of 2007 and their allocation averaged just 18.5% from June 11, 2008, to March 11, 2009—the period during which the S&P 500 lost just under 45% of its value.

Starting in January, Hepburn plans to provide the average allocation for the prior 13 weeks at the beginning of each quarter for retail investors to use to rebalance their portfolios.

Tactical Approach

An investor who owns mostly ETFs might prefer to use the NAAIM results to rebalance just once a year instead of triggering transaction charges each quarter, he says. In that case, he would use the most recent data.

"This is not a method for clients to do frequent trading but to catch those major trends," he says. "If investors could have done that, there would be a lot fewer retirements being put off."

Kathleen Piaggesi, a certified financial planner at K/A/P Planning Advisory in Scarsdale, N.Y., says she abandoned the buy-and-hold approach after experiencing devastating losses in the third quarter of 2008. She spent a year attending breakfast meetings and other briefings talking to mutual fund managers who were using a more tactical asset allocation approach, including long/short and merger arbitrage ideas.

Inspired by the example of the endowment fund of the Cooper Union for the Advancement of Science & Art, which moved to more alternative assets to diversify away from strategies that went bust, she says she's willing to give up gains as high as 45% in any one year in order to have some portion of her clients' money in noncorrelated assets that don't necessarily have a lot of upside potential.

"This is the new normal," she says, citing the now-ubiquitous phrase coined by Pimco. "It's about looking out over the horizon and asking, What are the risks going to be and how can I be prepared for them for at least some of my money?"

Absolute Return

For Clifford Michaels, president of the Financial Planners Assn., the great uncertainty in the markets is pushing him more toward absolute return ideas, which use short-selling, futures, options, arbitrage, and leverage to deliver positive returns to clients regardless of market gyrations. He's investing in a long/short fund at JPMorgan Chase (JPM), which was up 9% in 2008, and international bond funds that are moving inversely with the dollar.

"There's really nowhere to go for your safe money. Bonds and CDs aren't paying anything," he says. "So you have to be creative and maybe the old rules have to be redefined. Maybe you don't put as much focus on rebalancing as finding new ways [to think] out of the box."

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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