As the end of the year approaches, the investment industry is gearing up for the annual portfolio rebalancing act. An article in InvestmentNews gives the following example:
Still, advisers’ plan to stick to their long-term asset allocation was likely thrown out of whack this year by the divergence of stocks and bonds. For example, a client who started the year with a simple 60/40 portfolio comprised of the $287 billion Vanguard Total Stock Market Fund (VTSMX) and the $247 billion Pimco Total Return Fund (PTTAX), the two largest mutual funds in the world, would now have 66.3% invested in stocks and just 33.7% invested in bonds, pushing beyond the typical 5% leeway most advisers give their asset allocation.
To illustrate the divergence from asset allocation historical averages, here is a chart from a Vanguard blog post:
While the collective allocation of mutual funds and ETFs to equities has recently reached 57%, the biggest divergence from the historical median is in international equities. Allocation to bonds is also relatively high, while the proportion in domestic equities is close to the 20-year median.
The higher allocations to international equities and bonds are at the expense of cash. Assets in money market funds are at a historical minimum of about 18% in the observation period. This has undoubtedly been caused by the low interest rate policy of the Fed, which depressed returns of such funds. The danger is that when interest rates eventually rise, bond prices will suffer:
So in an intermediate-term bond fund, with an average duration of four to five years, the loss would be about 4% to 5%.
This means that it may actually be prudent for an average investor to shorten the duration by moving a part of investment in bonds to money market funds.
Historically, the proportion of international equities in the total equity allocation has been about 19%; currently, it is about 27%. The argument for keeping it high is a relatively low valuation of foreign stocks compared to domestic ones:
When rebalancing portfolios, it is also important that investors understand the true exposure of their mutual fund holdings to various asset classes. The recurring problem, which Alpholio™ addressed in several prior posts, is that managers in some equity funds (especially value strategies) hold a large percentage of assets in cash. As a result, asset allocation in the overall portfolio can be distorted unbeknownst to the investor.
Alpholio™ provides current information on the exposure of mutual funds to various asset classes. This information is not obtained from the regulatory filings or selective disclosures of fund holdings, which suffer from a number of problems.
In sum, when rebalancing a portfolio either on a fixed schedule or as a result of divergence from prior allocations, investors should take into account a broader market and interest rate context, rather than just follow rigid rules.
An article in The New York Times describes a recent build-up of cash positions in equity mutual funds:
Many fund managers have quietly been raising their cash positions. In their latest reporting periods, according to Morningstar, the average equity mutual fund held 9.7 percent in cash, up from 8.8 percent in the previous three-month period.
The article discusses the following funds with high cash positions:
Managers of these funds cite several reasons for keeping substantial cash cushions:
- Inability to find sufficiently undervalued stocks
- Paramount need for capital preservation in market downturns
- Ability to get in on best buying opportunities during market sell-offs
- Global markets currently being fully valued.
The argument of a full- or over-valuation of stocks backfires when applied to the existing equity holdings of a fund: If at present the manager does not want to use the surplus cash to add to these positions, this implies that they have a limited appreciation potential, are fully valued or even over-valued. With that diminished reward-to-risk ratio, the fund should sell these equity holdings and increase its cash position even further.
The other arguments hinge on an assumption that a major market downturn is imminent and will have a significant magnitude, which justifies a high cash position. This leads to market timing, at which, statistically, most managers fail. Meanwhile, such funds do not realize their full potential in a rising market. Investors end up paying the price both ways.
As Alpholio™ stated in previous posts, the decision about the percentage of cash should really be left to the investor at the portfolio level rather than to a manager of each mutual fund. Otherwise, the investor is forced to constantly monitor cash positions in funds and make offsetting portfolio adjustments to stay on the overall asset allocation track. Alpholio™ helps with that by providing a visibility into the equivalent exchange-traded product (ETP) positions of a fund in between its periodic regulatory filings.
An article on Bloomberg describes major market timing efforts by “value” managers who currently cannot find underpriced stocks and therefore have large cash positions in their mutual funds:
This problem was already addressed in a previous post. While the managers are attempting to generate returns superior to those of their funds’ benchmarks and to reduce fund volatility, they are also distorting asset allocation in their investors’ portfolios. It should be up to an investor to decide what specific percentage of cash he/she wants in the portfolio, and not up to a manager of the equity portion of the portfolio.
So, how to solve this problem to the satisfaction of both parties? The manager should keep only a minimal amount of cash at hand, and temporarily invest the rest of it in an index instrument, such as an exchange-traded fund (ETF), that follows the fund’s benchmark. This way, the fund would be almost fully invested in equities, and there would be not forgone gains if the market kept going up. (The managers’ argument for keeping cash is not that a collapse of the equity market is imminent; it is that no sufficiently deep value stocks are available.)
This proposal certainly sounds like a blasphemy — after all, these managers want to show off their skill in picking individual stocks, instead of becoming “index huggers.” However, it does keep the best interest of investors in mind — to at least keep up with the market. Since most market timing efforts backfire, staying close to fully invested is the only prudent thing to do.