Author Topic: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?  (Read 2833 times)

Louisville

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Iím trying to figure out if Iím rebalancing myself crazy for no reason. 

Letís say, for simplificationís sake, that Vanguardís Total World Stock Index, or VTWS (Iím making this up), today consists of 60% US, 30% Developed Foreign , and 10% Emerging Markets.

Letís also say that my target AA is also 60% US, 40% Developed Foreign, and 10% Emerging Markets. I have a choice between holding all VTWS or holding three different index funds to match my AA.

If I go the one fund way:  As time goes by, VTWS drifts as economies change Ė thatís what broad indices do, they donít hold steady percentages, they just follow whatís out there. So VTWS will no longer match my AA. But thatís not even my main concern. If Iím in just this one broad index, Iím missing out on gains captured when rebalancing between my three buckets as they rise and fall relative to each other. Right?

If I go the three fund way:  Iíve got to mess with rebalancing annually, quarterly, whenever.

Now, I donít mind rebalancing. Iíve got a cool spreadsheet, everything is a Vanguard, Iím smart about not incurring transaction fees, etc.  But, Iím not so sure Iím going to want to mess with it as I age.

So, this is really a math problem. If oneís AA is similar to a broad index, is holding smaller, more specialized buckets going to yield a greater return?

Heckler

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #1 on: February 27, 2015, 08:49:07 AM »
http://canadiancouchpotato.com/2015/01/15/couch-potato-model-portfolios-for-2015/

CCP might be able to help decide.  Dan did the same this year.

Louisville

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #2 on: February 27, 2015, 09:12:26 AM »
http://canadiancouchpotato.com/2015/01/15/couch-potato-model-portfolios-for-2015/

CCP might be able to help decide.  Dan did the same this year.
Read through this a couple of times. Not seeing how it addresses my question. CCP is comparing various AAs, but I'm not seeing anything about the relative value of rebalancing small market slices vs. holding the whole market.

Aphalite

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #3 on: February 27, 2015, 09:15:42 AM »
So, this is really a math problem. If oneís AA is similar to a broad index, is holding smaller, more specialized buckets going to yield a greater return?

Yes, as long as the buckets that you have have less than 100% correlation to each other, you will get gains on rebalancing

Broad funds do not always have the ability to rebalance constantly (without generating turnover and thus capital tax gains) because of investor behavior. If the major component of the broad index tanks and drags the price down with it, investors who sell the fund will limit the fund's ability to rebalance (net outflow)

In bull markets this is less of a problem, as the fund can use new investor cash or dividends received to rebalance on an ongoing basis

Louisville

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #4 on: February 27, 2015, 10:10:45 AM »
So, this is really a math problem. If oneís AA is similar to a broad index, is holding smaller, more specialized buckets going to yield a greater return?

Yes, as long as the buckets that you have have less than 100% correlation to each other, you will get gains on rebalancing

Broad funds do not always have the ability to rebalance constantly (without generating turnover and thus capital tax gains) because of investor behavior. If the major component of the broad index tanks and drags the price down with it, investors who sell the fund will limit the fund's ability to rebalance (net outflow)

In bull markets this is less of a problem, as the fund can use new investor cash or dividends received to rebalance on an ongoing basis
[Bolding mine]. But, the fund is an index fund. It won't rebalance. It will just truck on, and the components that didn't tank will now be a larger share of the index and the fund. Right?

Aphalite

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #5 on: February 27, 2015, 10:40:59 AM »
[Bolding mine]. But, the fund is an index fund. It won't rebalance. It will just truck on, and the components that didn't tank will now be a larger share of the index and the fund. Right?

Sure, but then that means you have a different AA than the index, which means that you should be holding the individual components anyways since you don't agree with a shifting AA

It's like if you took the total US market fund, looked at it, and said, I don't agree with how the index is allocating by market cap, I want one that equally weighs all stocks in the market - you can't rely on the index to do that so you would have to splice a fund together yourself

hodedofome

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #6 on: February 27, 2015, 10:44:09 AM »
Yeah pretty much what Aphalite said. You either believe the market knows more than you, or you know better than the market.

skyrefuge

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Re: More Narrow Indices vs. Fewer Broad Indices Ė Is Rebalancing Worth It?
« Reply #7 on: February 27, 2015, 01:37:56 PM »
If Iím in just this one broad index, Iím missing out on gains captured when rebalancing between my three buckets as they rise and fall relative to each other. Right?

Just to be clear, rebalancing only boosts returns if the classes that you're rebalancing all have the same expected returns and mean-revert to those expectations. Otherwise, it actually hurts (theoretical*) returns.

This is easily seen in the standard rebalancing between stocks and bonds. Since stocks have a higher expected return than bonds, most of your rebalances will involve moving money from a higher-returning asset to a lower-returning one.

In the case of your 3 stock funds, they're probably closer to having the same expected returns than stocks-vs.-bonds, though I think most would say Emerging Market has a higher expected return than the other two. If so, then you still might not be boosting returns by rebalancing.

* Even though rebalancing hurts your portfolio's theoretical returns, it helps your actual returns by keeping your portfolio's risk profile in line with your actual risk-tolerance. That will increase the chances of you staying-the-course, and the boost you get from staying-the-course will outweigh the losses you get from rebalancing. That's why we do it.