International diversification and rebalancing

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
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International diversification and rebalancing

Post by Rooster » 26 Feb 2013 10:39

My equity portfolio is all broad based index funds, pretty much by world market cap at time it was set up (some overweight for Canada and Emerging markets).

I had initially planned to periodically rebalance back to original allocation for each asset class. I'm questionning that now. Basically thinking that would go against a basic principle of indexing -ie. I don't know which country or stock will do better in the future, so buy all according to market cap and let God sort it out :). Within a multicountry index fund, the geographical makeup fluctuates (take VT or VXUS for example). It's actually country agnostic. Within VT, it just holds global companies as per their relative market cap.

I can understand need ro rebalance between differeing asset classes (stocks, bonds, reits) better than within an asset class (say equities). If stocks for country X have grown faster than others, why should I hold them below their global market cap?

I can also understand people wanting to overweight certain assets they feel will yield better returns (ie. small caps, emerging markets, value stocks, etc.), but I have no reason at all to, say, peg the US or EAFE to a set percentage. I'm thinking doing so is actually actually akin to "picking"/active management and I have no basis to do so. I'd prefer to just "index" my international holdings (save maybe for a slight overweigh of emerging markets for growth prospects and Canada as a bit of a currency anchor).

I would have just bought VT, but preferred the depth of VTI + VXUS.

Thoughts?

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Re: International diversification and rebalancing

Post by ghariton » 26 Feb 2013 11:56

As far as I can see, rebalancing is based on the premise of "reversion to the mean". That is, asset classes which have done better than average will be below average for a period in the future, and asset classes that have done worse than average will do better than average in the future. This applies no matter how you define asset classes -- stocks versus bonds, industrials versus utilities, (controversially) value versus growth, and also various countries.

Within the category of stocks there is a body of empirical evidence that individual stocks show momentum in the short run, i.e. winners keep winning and losers keep losing. But they show reversion to the mean in the medium and long term. So if your horizon is in terms of years, rebalancing may give you a boost. (Some estimate this boost at 0.5% to 1% a year.) Similarly there is evidence that returns on stocks and bonds are negatively correlated, so there is some form of reversion to the mean there.

I haven't seen empirical studies of rebalancing among countries. But the question is the same: Do countries' economic performance show reversion to the mean, and more importantly, how quickly? If you think that the answer is "Within my investment time frame", then rebalance. Otherwise, not.

George
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Re: International diversification and rebalancing

Post by Rooster » 26 Feb 2013 12:01

ghariton wrote:As far as I can see, rebalancing is based on the premise of "reversion to the mean". That is, asset classes which have done better than average will be below average for a period in the future, and asset classes that have done worse than average will do better than average in the future. This applies no matter how you define asset classes -- stocks versus bonds, industrials versus utilities, (controversially) value versus growth, and also various countries.

Within the category of stocks there is a body of empirical evidence that individual stocks show momentum in the short run, i.e. winners keep winning and losers keep losing. But they show reversion to the mean in the medium and long term. So if your horizon is in terms of years, rebalancing may give you a boost. Similarly there is evidence that returns on stocks and bonds are negatively correlated, so there is some form of reversion to the mean there.

I haven't seen empirical studies of rebalancing among countries. But the question is the same: Do countries' economic performance show reversion to the mean, and more importantly, how quickly? If you think that the answer is "Within my investment time frame", then rebalance. Otherwise, not.

George
Thanks. A point I have difficulty with (same for currency fluctuations) is how do you determine the "mean".

For example, i set my AA within stocks based on global market cap at the time. By reverting back to that through the next decades, I'm betting that that was the mean to which markets will revert back to (and hence enhance my returns by rebalancing). Similarly for currency, what's the mean exchange rate for cad/usd?

Thanks again.

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Re: International diversification and rebalancing

Post by ghariton » 26 Feb 2013 12:20

Rooster wrote:[how do you determine the "mean".
Look at relative performance. Compare the returns of various assets. Equivalently, if one asset has done better than other assets in your portfolio, then the value of that asset grows as a percentage of your portfolio. Rebalancing then amounts to selling those assets whose relative value has grown and buying those assets whose relative value has dropped.

I have bever seen rebalancing based on currencies, but the logic seems to imply the following. Say your portfolio contains assets, 70% of which are denominated in U.S. dollars and 30% in Canadian dollars. After a few years, you look at your portfolio and find that the assets are now 50% in U.S. dollars and 50% in Canadian dollars. This suggests that Canadian assets have been doing better than U.S. assets, for whatever reason -- the reason doesn't matter to rebalancers. If you believe in reversion to the mean, that means that there will be a period coming up when U.S. assets will outperform Canadian assets. A rebalancer might then sell 20% worth of his Canadian assets and buy U.S. assets with the proceeds, getting back to 70%/50%.

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Re: International diversification and rebalancing

Post by newguy » 26 Feb 2013 12:22

ghariton wrote:I haven't seen empirical studies of rebalancing among countries. But the question is the same: Do countries' economic performance show reversion to the mean, and more importantly, how quickly? If you think that the answer is "Within my investment time frame", then rebalance. Otherwise, not.
That brings up the applications of co-integration again.

Mean Reversion across National Stock Markets and Parametric Contrarian Investment Strategies

I find the reversion time is too long and uncertain for it to be tradeable compared to other instruments (which I also don't trade).

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Re: International diversification and rebalancing

Post by Rooster » 26 Feb 2013 13:06

ghariton wrote:
Rooster wrote:[how do you determine the "mean".
Look at relative performance. Compare the returns of various assets. Equivalently, if one asset has done better than other assets in your portfolio, then the value of that asset grows as a percentage of your portfolio. Rebalancing then amounts to selling those assets whose relative value has grown and buying those assets whose relative value has dropped.

I have bever seen rebalancing based on currencies, but the logic seems to imply the following. Say your portfolio contains assets, 70% of which are denominated in U.S. dollars and 30% in Canadian dollars. After a few years, you look at your portfolio and find that the assets are now 50% in U.S. dollars and 50% in Canadian dollars. This suggests that Canadian assets have been doing better than U.S. assets, for whatever reason -- the reason doesn't matter to rebalancers. If you believe in reversion to the mean, that means that there will be a period coming up when U.S. assets will outperform Canadian assets. A rebalancer might then sell 20% worth of his Canadian assets and buy U.S. assets with the proceeds, getting back to 70%/50%.

George
Thanks. I don't think i expressed myself very clearly in my post. I briefly read over newguy's article and it clarified some concepts.

Inherent in my question was a belief that the value or trend path between different country's indexes could well differ. I would need to know what they were in order to rebalance properly. This would be akin to making a fundamental analysis which i'm unable to do with any confidence and hence prefer to index broadly.

If, for example, a person sets their AA at 50/50 between US and EAFE as that was the global market cap at the time it was set. The next year, another person sets it at 40/60 between US and EAFE as the market cap of each relative to each other had drifted to that. Both rebalance periodically to maintain their original AA. One will do better than the other depending on what the fundamental value makes it "revert" to. If 50/50 turns out to overweight the US, the first person, by preriodically pushing it back to 50/50 will constantly be selling undervalued assets (eafe) to purchase overvalued assets (US). And this, only if we can assume that their relative weight should remain equal in the first place.

On currency, I did not mean rebalancing but whether or not to hedge (sorry for not mentionning it). We often hear that currencies "revert to mean". I'm not sure what that means. Is the mean parity or the cdn dollar at 60 cents or somewhere in between or outside of that. Person A can be buying at parity unhedged on the belief that it will likely revert to means. Ditto for a person buying at 60 cents. How can both be true?

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Re: International diversification and rebalancing

Post by newguy » 26 Feb 2013 13:10

Rooster wrote:Is the mean parity or the cdn dollar at 60 cents or somewhere in between or outside of that. Person A can be buying at parity unhedged on the belief that it will likely revert to means. Ditto for a person buying at 60 cents. How can both be true?
The mean is the mean and it can be calculated. When the loonie was 66¢ the mean over the previous x years was say about $1.00. So the person would expect it to revert to that number (if of course currencies are mean reverting).

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Re: International diversification and rebalancing

Post by Rooster » 26 Feb 2013 13:15

newguy wrote:
Rooster wrote:Is the mean parity or the cdn dollar at 60 cents or somewhere in between or outside of that. Person A can be buying at parity unhedged on the belief that it will likely revert to means. Ditto for a person buying at 60 cents. How can both be true?
The mean is the mean and it can be calculated. When the loonie was 66¢ the mean over the previous x years was say about $1.00. So the person would expect it to revert to that number (if of course currencies are mean reverting).

newguy
So, if one believes in mean reversion in currencies, one should buy unhedged when the cad/usd rate is higher than the mean and hedged below?

Ditto for setting allocations to different country's stocks. Should set it on the mean relative weight based on historicals?

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Re: International diversification and rebalancing

Post by newguy » 26 Feb 2013 13:18

Rooster wrote:So, if one believes in mean reversion in currencies, one should buy unhedged when the cad/usd rate is higher than the mean and hedged below?

Ditto for setting allocations to different country's stocks. Should set it on the mean relative weight based on historicals?
No because you're missing some variables. One is the simply the chance that you're right. Usually you say you're right at the 95% confidence level which is what the vanilla algos test for. The other is the time it takes for mean reversion to happen. With currencies there is a cost to be hedged so that may not prove profitable if it takes too long.

newguy

add: there's probably not enough reliable data to judge if many of these things actually are mean reverting. Look how long CAD/USD or TSX/DJIA stray from the mean.

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Re: International diversification and rebalancing

Post by Rooster » 26 Feb 2013 13:34

newguy wrote:
Rooster wrote:So, if one believes in mean reversion in currencies, one should buy unhedged when the cad/usd rate is higher than the mean and hedged below?

Ditto for setting allocations to different country's stocks. Should set it on the mean relative weight based on historicals?
No because you're missing some variables. One is the simply the chance that you're right. Usually you say you're right at the 95% confidence level which is what the vanilla algos test for. The other is the time it takes for mean reversion to happen. With currencies there is a cost to be hedged so that may not prove profitable if it takes too long.

newguy

add: there's probably not enough reliable data to judge if many of these things actually are mean reverting. Look how long CAD/USD or TSX/DJIA stray from the mean.
Thanks.

Point taken on cost of hedging. Remember deciding to go all unhedged when i figured costs (mer + tracking errors) to be around 15% over 20 years or so. At parity, seemed like a very good bet.

Still don't know what to do with regards to AA within equities. :(. Had no idea what to bas eit on when I set it, so went with global market cap at the time. Now that that changes, I'm up in the air again on this.

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Re: International diversification and rebalancing

Post by newguy » 26 Feb 2013 13:48

Rooster wrote:Still don't know what to do with regards to AA within equities. :(. Had no idea what to bas eit on when I set it, so went with global market cap at the time. Now that that changes, I'm up in the air again on this.
If I was to do something like that it would be sector rebalancing. So many companies are global nowadays I think international diversification is more about government confiscation than profitable nations. There has been some talk here so try a search.

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Re: International diversification and rebalancing

Post by Quebec » 26 Feb 2013 19:21

ghariton wrote:I haven't seen empirical studies of rebalancing among countries.
Books by W. Bernstein provide many examples. If you cherry-pick your example, rebalancing stocks bwt say Japan and the US can look great. Or it can look awful, depending on the period.

But in general, suppose that two developed nations' stock indices have the same average returns and standard deviations, but are imperfectly correlated. Splitting your investment half and half, and rebalancing yearly, should produce a portfolio with a lower SD (and slightly higher return?) than investing in one of the indices only. (I am ignoring momentum here.)

At least that's how I remember it.

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Re: International diversification and rebalancing

Post by Rooster » 27 Feb 2013 09:21

Quebec wrote: suppose that two developed nations' stock indices have the same average returns and standard deviations, but are imperfectly correlated. Splitting your investment half and half, and rebalancing yearly, should produce a portfolio with a lower SD (and slightly higher return?) than investing in one of the indices only. (I am ignoring momentum here.).
Can this reasonably be assumed for EAFE and US?

I believe that emerging markets can well be on a different growth path and thus would give it more leaway (already allocate slightly more than it's current weight), but am unsure for EAFE vs US. Are they historically close to 50/50 and can they reasonsably be assumed to be on similar growth curves over long periods (so that rebalancing makes sense -ie. It's likely that if one grows appart from the other, it will eventually revert back to close to 50/50)?

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Re: International diversification and rebalancing

Post by Quebec » 27 Feb 2013 17:25

We don't know in advance which asset class will have the best returns over the next decades, so we diversify!

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Re: International diversification and rebalancing

Post by Rooster » 27 Feb 2013 18:04

Quebec wrote:We don't know in advance which asset class will have the best returns over the next decades, so we diversify!
I'm on board with diversification, but rebalancing isn't diversification it's making a bet on future price movements. It's calling something likely overvalued and something else likely undervalued.

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Re: International diversification and rebalancing

Post by Shakespeare » 27 Feb 2013 18:21

Rebalancing is risk control. It may or may not boost returns.
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Re: International diversification and rebalancing

Post by Rooster » 27 Feb 2013 20:16

Shakespeare wrote:Rebalancing is risk control. It may or may not boost returns.
Thanks.

I understand that with respect to stock/bond rebalancing as bonds are less volatile and the two asset classes have lower correlations.

I have a harder time understanding with respect to US/EAFE rebalancing. Does it not depend on where you are in the "reversion to mean" cycle (as well as whether the two should grow the same as per fundamentals)?

If you set allocation at 50/50 at a time where US is overvalued to mean by 20% and eafe undervalued by 20% and both start reverting to mean after your initial purchase and setting your AA, you would be constantly buying a devaluating (too expensive) asset and selling an appreciating (too cheap) asset by rebalancing to 50/50. This would be riskier than doing nothing. Not only would you not be boosting return, you could be causing loses. On the flip side, if one asset starts getting ahead of itself (becoming too expensive) and the other not (less expensive), then rebalancing is good. Seems to me (and I'd love to be corrected) that it's flipping a coin. Could be good, could be bad and I have no reason to pick either (outside of a fundamental analysis on the prices of each that i would be confident in). Seems to me this is contrary to the principle of indexing (don't know, so take market returns as per market cap). In the same way that an index fund does not rebalance individual stocks or industries as per their initial allocation. It just rebalances to keep up with market cap.. It lets the market decide valuations.

This make any sense?

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Re: International diversification and rebalancing

Post by Shakespeare » 27 Feb 2013 20:51

You can not reliably predict where a cycle will stop.

Set broad limits and rebalance infrequently. Country-specific risks are still risks.
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Re: International diversification and rebalancing

Post by Rooster » 27 Feb 2013 21:05

Shakespeare wrote:You can not reliably predict where a cycle will stop.

Set broad limits and rebalance infrequently. Country-specific risks are still risks.
Thanks. Would it make sense to rebalance only based on large fluctuations on P/E and/or PB ratios? Basically, on changes in valuations?

One assets starts getting considerably more "expensive" and it gets less money. Something gets "cheaper" and it gets more.
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Re: International diversification and rebalancing

Post by Shakespeare » 27 Feb 2013 21:29

Most people recommend rebalancing on allocation targets. 5%/25% for example - 5% absolute or 25% relative off target. (Swedroe, IIRC.)
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Re: International diversification and rebalancing

Post by Rooster » 27 Feb 2013 21:33

Shakespeare wrote:Most people recommend rebalancing on allocation targets. 5%/25% for example - 5% absolute or 25% relative off target. (Swedroe, IIRC.)
That's what i set out to do.

But I've been thinking (always dangerous ;)). Basically, i assume things don't revert to mean for no reason. They do so because the mean is closer to their intrinsic value. Rebalancing, to me, is akin to value investing. Rebalancing blindly is a blunt instrument that may be good or bad (depending if the asset is pulling from the mean or reverting towards it). By attaching it to underlying valuation (buy more stuff that is cheaper and less that is more expensive), it seems less blunt. Basically, if asset A is too far away from its mean valuation, you don't buy it (or less of it) regardless of whether it is regressing to the mean or pulling away from it.

I rebalance with new purchases, so would allocate more money to whichever is cheapest as compared to its historical valuations (ie. I'd overweight new money to eafe in present market).

I'm making this up as i go along. Making any sense?

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Re: International diversification and rebalancing

Post by Shakespeare » 27 Feb 2013 21:45

Personally, in accumulation I would put money in whatever was under target, and only then address valuations (if I was not indexing).
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Re: International diversification and rebalancing

Post by ghariton » 27 Feb 2013 22:40

Rooster wrote: Making any sense?
Makes sense to me, if one is building portfolios the traditional way, i.e. by targeting a fixed percentage (or bands around these) for different asset classes. I personally don't do that. I keep an amount in fixed income that will produce a target cash flow and invest the rest in equities. So new money goes into equities, and if I need money, it comes out of equities. Within equities, I do what Shakespeare said -- buy a mix of VTI, VEA and VWO that is very roughly proportional to market capitalization weights. I use new money, or sale of equities when I need money, to move toward the targets -- I don't actively rebalance.

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Re: International diversification and rebalancing

Post by Rooster » 27 Feb 2013 22:43

ghariton wrote:
Rooster wrote: Making any sense?
Makes sense to me, if one is building portfolios the traditional way, i.e. by targeting a fixed percentage (or bands around these) for different asset classes. I personally don't do that. I keep an amount in fixed income that will produce a target cash flow and invest the rest in equities. So new money goes into equities, and if I need money, it comes out of equities. Within equities, I do what Shakespeare said -- buy a mix of VTI, VEA and VWO that is very roughly proportional to market capitalization weights. I use new money, or sale of equities when I need money, to move toward the targets -- I don't actively rebalance.

George
And do the tagets (within equities) move along with changes in global market cap or stay set?

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Re: International diversification and rebalancing

Post by ghariton » 27 Feb 2013 23:30

Rooster wrote:And do the tagets (within equities) move along with changes in global market cap or stay set?
They pretty well stay set at the average of the last couple of years.

It doesn't matter that much. Remember that I'm only adding new money (or taking out spending money).

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