and the winner is....

Back in early October I posted a blog in which I argued that treasury type securities had taken over the role of hedge funds as an asset class that was almost totally de-correlated from the rest of the market. I also remarked that it was still too early to jump to any conclusions given that there still remained roughly 3 months before the end of the year and that anything could happen until then. 

Well, here we are again, roughly a week before the year ends, to asses the performance of the various asset classes. The graph in this blog is more comprehensive as it includes a larger number of asset classes and other instruments (commodities and hedge funds are technically not considered to be asset classes).

My first observation would be to highlight treasuries that have produced the only positive performance for the year. All the remaining asset classes which include global stocks, commodities, global real estate and hedge funds have been overwhelmingly negative. Hedge funds have lost somewhat less than the other asset classes but still a whopping 25% of their value (an average figure) has vanished into thin air, making it one of the worst years in hedge fund history.

What is even more astonishing to note is that the performance of treasuries are almost a mirror image of hedge funds. A cursory glance would suggest that the correlation is almost perfectly negative although in reality hedge funds have lost significantly more than the amount that treasuries have gained!

Notice also how commodities have shed all the massive gains it had accumulated up until the middle of the year. The monumental losses have brought the performance of commodities in line with the worst performers in the list (stocks and real estate).

This has been a year full of surprises (I mean who would have thought that treasuries would have been hoarded and that commodities would have posted records both on the upside and downside?). One can be confident that the performance picture for next year will probably look very different from those of 2008!

A system-wide failure...

The investment profession has taken a significant setback over the past couple of months, losing practically all the credibility it had garnered over the years. One has to look no further than 10 year treasury yields (currently approaching a record low of 2%) or the spread between 3 month libor and 3 month treasuries (still at record levels) to get a feel of the extent of damage and distrust in the system. What is disturbing in the current environment is not only the sheer monetary scale of losses involved but also its scope. Never mind that Madoff, a master illusionist successfully conned a large number of investors (including banks) for years when the whole financial system itself resembles a giant ponzi scheme. From the unscrupulous lenders who began selling mortgages to individuals that could ill afford them, to the banks that repackaged those same mortgages into so called "quality" tranches before dumping them on unsuspecting investors, to the rating agencies that issued bogus ratings on products that they did not even understand, to Greenspan, the "oracle" that did everything in his power to suppress any form of regulation, particularly with regards to the over the counter derivatives market, to Chief Executives at major banks that continued to claim that everything was under control when the truth was otherwise and to the SEC that preferred to ignore credible warning signs regarding Madoff.

The whole system it seems was rife with incompetence, greed, deceptiveness and other unethical behavior. No wonder then that confidence has sunk to record lows and shows complete indifference to the incessant government actions and pledges to fix the problem. It will take a lot more than plain rhetoric to restore trust that is so critical to the proper functioning of an economy.

More gloom and doom before the boom?

Taking a casual look at a few key indicators suggests that we should be embracing for further market turmoil in the coming year.The credit crunch which sprouted amid a severe housing recession shows no signs of abating despite significant efforts by policymakers to reassure investors that the crisis is "under control". Confidence is far from being restored and as a result, businesses and households are having trouble obtaining credit (just when they need it most) which means that we can expect large cutbacks on investments and consumption respectively, contributing in worsening the recession.
Both the 2 year breakeven spread (which measures the differential between 2 year nominal treasury yields and that of inflation protected securities) and the freefall in commodity prices corroborate with the expectations of a deepening recession through a deflationary cycle that is likely to dominate over the next two years.
If we add to this the loss in effectiveness of the Federal Reserve's key monetary policy tool (the result of a liquidity trap that forms as nominal interest rates approach 0 percent) and a Tobin's Q ratio (a well known ratio that compares the market value of a firm to that of its replacement or book value), signaling further downside for global stock markets, there frankly is not much out there to cheer about.
But then again, the forecasting profession is more notorious for having a dismal track record which means that the extreme bearishness that is being suggested at present may be nothing more than a giant smokescreen.

To rebalance or not to rebalance?

Rebalancing a portfolio (bringing the asset class weights to or close to their neutral weights) serves two essential purposes:
1. Preserving the defined risk profile of the portfolio over time
2. Increasing the probability of locking in market related performance gains by cashing in on outperforming investments (reducing the impact of a subsequent selloff in the investment) and buying more of underperforming investments (enabling the portfolio to capture greater returns from a subsequent rebound).
Rebalancing, together with diversification are amongst the core pillars of modern portfolio theory.
There is a caveat, however, that should be regarded carefully by those that employ rebalancing techniques when managing portfolios. It is that the effectiveness of rebalancing techniques depend largely on market conditions. In periods of market turmoil, rebalancing can prove to be counterproductive. Just like in the event of an earthquake, we are less likely to go about our daily chores, rebalancing is not necessarily the right thing to when market conditions are extraordinary.
The best way to illustrate this would be by taking an example of a "balanced" risk profile portfolio with an even split exposure to equities and bonds. Say, for example, that $1000 dollars is invested into equities and the remaining $1000 into bonds for a total portfolio value of
$2000 at the beginning of the year. Suppose that a financial crisis occurs and that by mid year, equities are down 30% whilst bonds remain flat (I know, its not very difficult to imagine such things these days). The portfolio value will be as follows:
Equities: $700
Bonds: $1000
Total: $1700
Suppose that right after the drop, the portfolio manager decides to rebalance with a final result of:
Equities: $850
Bonds: $850
Total: $1700
Suppose, also, that for the rest of the year, equity markets drop another 30% and bonds remain at the same level. Our portfolio at the end of the year will look as follows:
Equities: $595
Bonds: $850
Total: $1445
Now suppose that the manager did not rebalance at any time during the year. Our portfolio would end up as follows:
Equities: $490
Bonds: $1000
Total: $1490

We find ourselves with a portfolio that has a smaller exposure into equities but also with a better performance relative to the rebalanced portfolio. The non rebalanced portfolio total value stands at $1490 versus $1445 for the rebalanced portfolio. The difference (3.11%) may not seem like much but that is mainly becuase the total portfolio value is small!

Although this example illustrates the performance advantage of not rebalancing when markets are in turmoil (such as what we are experiencing at present), what it doesn’t show us as clearly is the increased risk of shifting the risk profile that not rebalancing results in. It is easy to imagine what would happen to the performances of the two portfolio examples in the event of a subsequent market rebound of similar scale to that of the drop.

Moral of the story: Rebalancing doesnt work well in times of extreme volatility but you have to weigh in the increased probability of a shift in risk profile if you decide to ignore rebalancing.