In our last blog, we outlined the theoretical underpinnings of how the natural relative volatilities and correlations in a portfolio of stocks can actually represent a component of that portfolio’s return over the long term. But simple implementations to capture this potential alpha source come with potential drawbacks, such as long periods of underperformance due to significant exposure to size and additional risk-adjusted returns left untapped.
In Intech’s own equity portfolios, we combine securities based on how their stock prices move relative to one another and the overall market. We believe that while equity markets may or may not be efficient, traditional approaches to representative benchmarks certainly are not. Hence, long-term enhanced return opportunities can be achieved by optimizing portfolio weights, based on stock volatilities and correlations. Systematic rebalancing is a core component of this process. We have found that consistently resetting portfolio holdings back to their optimization weights has historically captured attractive levels of rebalancing premium that have been reliably additive to overall portfolio returns in the vast majority of market environments, regardless of whether stock price movements alone may be offering any real gains.
A unique aspect of our investment approach is that we utilize security volatility, rather than return potential, in our optimization process. This is because we have found volatility to be an observable and accessible alpha source, regardless of market direction. Individual stock volatility characteristics also tend to be more consistent than return profiles, as shown below.
This exhibit is based on the one-year returns and volatilities (measured by standard deviations) for the individual stock components of the MSCI World Index over 28 years. These securities were segmented into thirds based on high, medium and low classifications for each characteristic. The chart shows the average percentage of stocks remaining in the same category the following year. Of note, while return characteristics proved to be highly variable—with only 30% to 35% staying within the same segment—volatility characteristics were much more reliable, particularly within the more extreme high and low segments, where they were, on average, more than twice as likely to maintain the same volatility hierarchy year over year.
Equally important to our optimization process is the correlation characteristics of each stock relative to each of the other portfolio holdings, as well as to the broader market. A combination of higher volatility and low correlation typically offers a greater rebalancing premium. For example, consider two pairs of stocks, one with perfect negative correlation and one with positive 0.5 correlation. With everything else being equal, rebalancing the first pair would generate a higher rebalancing premium.
Once optimization weights are determined and trading bands are put in place around them, the portfolio is systematically rebalanced when it deviates outside the bands back to these allocations on a periodic basis. The goal of this approach is to capture more stable excess return rates over time. This has, indeed, consistently been the case over full market cycles, as shown in the chart below, which highlights the steady long-term performance of the Intech U.S. Enhanced Plus strategy and a simple equal-weighted portfolio relative to the S&P 500 Index. Relative returns may lag over shorter time frames when the market is dominated by a handful of stocks for extended periods, such as the current investment climate, but it’s evident that a more sophisticated approach such as Intech’s does a better job at smoothing the ride by mitigating transitory headwinds.
In our experience, the key to capturing outperformance across full market cycles is to maintain a disciplined focus on the long-term trend, rather than become distracted by shorter-term periods that are deviating from the norm. Betting against market mean reversion, i.e., market stability, over the long term rarely ends well. In other words, gamblers may beat the odds from time to time, but long term the house usually wins.
Go Back to Basics
We’ve shown that a sophisticated approach to diversification can add significant value above a cap-weighted benchmark over the long term. If you’re curious where today’s concentrated market fits in a historical context, or want a better understanding of the theoretical basis of the rebalancing premium, check our latest paper, “Does Rebalancing Still Make Sense?”
The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Hypothetical performance results presented are for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.