A Rebalancing act

Balance

Balancing Act by Dion Wright.

Hillary Till, from the French EDHEC Risk and Asset Management Research Centre, published a very instructive study  (copy here) on commodities. She touched on a couple of interesting tools which are vital to improving our bottom line. I’ll start with the unequivocal advantage of rebalancing a portfolio periodically; which not only safeguards investments, but furthers returns.

In her own words, in a study from Erb and Harvey,

They
examine the returns of sixteen commodity futures contracts over the
period, 1982 to 2004. The average correlation of individual commodities
with one another was quite low: only about 9%. The average standard
deviation of the commodities that they studied was 25%. It turns out
that combining lowly correlated, highly volatile instruments can result
in additional index-level returns.

Erb and Harvey show mathematically that “when asset variances are high and correlations are low,” the diversification return from rebalancing can be high. For example, “for an equally weighted portfolio of 30 securities with average individual security standard deviations of 30 percent a year and average security correlations ranging from 0.0 to 0.3, the diversification return [alone] ranges from 3.05 percent to 4.35 percent.” This return is separate from any returns due to each individual commodity within the index.

[…]

So even if the individual futures contracts in an equally-weighted
index have returns that oscillate around zero, the rebalancing effect
plus collateral returns can add up to meaningful numbers.

I
liked that, an additional 3 to 4 percent return due to… rebalancing a
well diversified portfolio. If we consider the leverage effect —with a
collateral which is usually around 5 % for commodity futures— the overall
returns can amount to a healthy… 60 to 80 %. And, there’s still an additional silverlining, the Sharpe ratio (the return/risk ratio) of the highly leveraged future asset portfolio remains unchanged.

In comparing portfolios, a larger Sharpe ratio is better; or, if two portfolios show equal risk, the one with the highest return is evidently preferable. And since I mentioned the Sharpe ratio, I recommend visiting Bob Fulks very comprehensive explanation and examples (copy here) to get a good update on this very useful ratio.

It’s interesting to note that there are several very popular methods, with good track records, that rebalance their portfolio assets once a year. Two, that I remember, are Michael O’Higgins’ the Dogs of the Dow and Bill Bernstein’s Couch Potato portfolio methods. Efficient Solutions has a nice piece of software to determine optimum portfolios: MVOPlus.

Surely, a well diversified portfolio —and commodities have the advantage of having low correlations, as opposed to stocks— has a tendency to regress to the mean; which can be exploited to make a pretty penny, by simply rebalancing the assets to fixed proportions periodically.