Rebalancing vs. Buy & Hold

In these tumultuous times, one wonders what sort of investment strategy to adopt. The modern portfolio theory rule of thumb would be to "stick to one's guns" by remaining thoroughly diversified and keeping a disciplined approach to rebalancing the portfolio when asset class weights deviate "too far away" from a defined optimal value.

Rebalancing can actually be tricky in times of high volatility not only because it may require quick action to counter large sways in the market but also because of the additional transaction costs that frequent "adjustment" trading could entail.

There is, however, an optimal level of rebalancing that can be implemented, depending on market volatility conditions. Studies show, for example, that rebalancing (adjusted for transaction costs) outperforms buy and hold strategies in periods of high volatility where markets experience sharp reversals. The opposite occurs in bull or bear market conditions, where the markets follow a clear trend. In this environment, buy and hold strategies tend to outperform rebalancing.

An optimal portfolio allocation strategy would therefore be one that is a function of the volatility levels of the markets. When volatility levels spike, as they have over the last couple of weeks, it would trigger a rebalancing signal for the portfolio. This could be in the form of a tightening of the rebalancing band limits of the respective asset classes. In contrast, when volatility levels are subdued, those same band limits should widen, reducing the probability of rebalancing but not eliminating them altogether, which would be risky, especially in transition periods from low volatility to high volatility.

A double dip?

According to the latest remarks from the Fed, the stimulative policy that began soon after the sub-prime crisis began in 2007 is likely to remain for some time to come. If we read between the lines, this would basically mean that the Fed is becoming increasingly pessimistic on the growth prospects of the economy and rightly so, considering the growing deficits that the U.S. and Europe are facing. In fact, as we have been saying since the end of 2008, this crisis is likely to remain with us for at least another couple of years. There is no quick way out of it, unless a very aggressive form of "financial repression" combined with hard core austerity is forcibly implemented, but if the U.K. riots are any sign of how ugly things can get, there doesnt seem to be much that can be done in the short run.
Market sentiment in this environment has become risk averse to such a degree that even treasuries, that recently lost their triple-A rating, have actually been rallying. This would be the second time in four years that "pundits" have gotten the direction of interest rates seriously wrong.
In summary we should be embracing ourselves for a global "double dip" as the U.S. increasingly embarks into what looks like an austerity program in disguise!

A revised Big Mac Index...

One fascinating index that has gained in popularity through the years is the Big Mac Index that is published by the Economist newspaper. It is interesting because it provides a very different approach to measuring the over or under valuation of exchange rates, based on the Purchasing Power Parity (PPP) theory which states that in the long run, the exchange rates between countries should adjust themselves to bring about parity in prices.
As the "Big Mac" is a commodity that is readily available in most parts of the world and because its price is very easy to obtain prices, it is very suitable for making cross comparisons.
One large drawback with the measure, however, has been that it does not adjust for differences in productivity which means that for emerging markets with cheaper labor, it will tend to introduce an underweighting bias to the figures. This bias is confirmed by a simple regression of the price of a Big Mac to GDP per capita. There is a clear positive correlation between the two.
In order to account for this, the Economist recalculated its figures by adjusting for differences in productivity. The end results are very different from the original calculations. China, for example, which was thought to have a currency that was undervalued to the dollar, according to the original figures, now finds itself slightly overvalued with the new calculations! It is also interesting to note the substantial overvaluation of the Brazilian Real and the continued overvaluation of both the Swiss Franc and the Euro.
In these times of growing uncertainty and rumors that official CPI figures may be rigged, the Big Mac index provides a more reliable measure of the PPP adjusted currency exchanges.