(re)BALANCING ACT

Symbol Scales is made of stones of various shapes

Rebalancing is a portfolio management tool used to re­align investor’s holdings with the original portfolio de­sign. There are several different rebalancing methods. We use the “percentage-of- portfolio” method. This method sets rebalancing thresholds and guides the portfolio back to these thresholds when market forces push it out of line. Our thresholds are plus or minus 5% of the asset class target weight. For instance, if a portfolio has a target allocation of 60% stocks, this method rebalances if stocks reach either 65% or 55%. Other methods include calendar rebalancing, constant mix, and buy and hold, to name a few. Portfolio managers must weigh benefits and costs when considering which method to use.

As stated above, a portfolio that drifts significantly from the intended mix can introduce unintended risks that could jeopardize desired results. Rebalancing is a way to make sure that a portfolio is realigned and managed to achieve the goals of the individual investor. The meth­od we use has the practical effect of selling the winners and buying the losers. This yields the additional benefit of potentially selling overpriced assets and buying under­priced ones. Markets price assets by discounting future po­tential returns to the present, so if an asset rises in price, our expectations for the asset would decrease, and vice versa. This approach fits quite well philosophically with our value approach to investing.

As there is no free lunch in investing – except for diversifi­cation – rebalancing does have costs. The two primary costs in rebalancing are transaction costs and taxes. These costs are the reason we don’t use either a specified calendar rebalancing method or the constant mix approach. In our view, the costs of these approaches outweigh the benefits. We manage asset allocation portfolios from many vantage points. Creating an asset allocation portfolio is not strictly a problem of how to invest stocks versus bonds. We also look at how a portfolio is allocated across market capital­ization, style, geography and credit quality. The following paragraphs outline how our asset allocation portfolios are weighted in each of the above categories.

We have a 3% overweight in equity versus fixed income for all of our asset allocation portfolios. Even though the equity markets have made a good run the last several years, we still see stocks as more attractive than fixed income. Thus our portfolios were rebalanced to maintain this universal 3% overweight versus the targeted benchmark. The do­mestic equity portion of the portfolios previously had a 15% large cap underweight versus the Wilshire 5000® Total Market Index. The offsetting overweight was in US small caps. Our rebalancing reduced the underweight in large cap stocks by swapping some of our previous overweights in mid and small caps into large caps. This is designed to reduce volatility in the portfolio, and provide greater protection in the event of a market downturn. At the end of last year, we added a new allocation to the US large cap core category. The intent of this allocation was to add a manager that can provide greater downside protection during falling markets. We utilize the FMI Large Cap Fund and BBH Core Select Fund in this space. We also replaced the Ameristock Fund with the Dia­mond Hill Large Cap Fund in large cap value at the end of last year. During the most recent rebalance, we reallocated the portfolio to have an equal weight across the large cap categories of value, core, and growth. We believe the large cap category is well positioned, and do not expect any changes in the near future.

We split the international allocation into a value and growth category. Previously, we had one fund in the Non-US category. This change ac­complishes two goals. First, it reduces individual manager risk in the catego­ry. Second, it creates a better balance between value and growth in the non-US stock category. The current portfolio breakdown between US and non-US stocks is approximately 70% US and 30% non-US. Even though this may seem quite a large allocation to non-US equity, it is actually signifi­cantly underweight relative to the total world market.

The MSCI ACWI All Cap® Index, which captures 99% of global stock markets, has a mix of 49% US stocks and 51% non-US stocks. Again, by this measure, we’re actually sig­nificantly underweight foreign equities. We’re not ready to go to a full market weight on foreign stocks, as we believe the US still offers the safest and most developed legal and capital market systems for investors. Fur­thermore, many US companies generate revenue from overseas, allowing us to participate in foreign growth as investors in domestic firms. Thus we don’t foresee reduc­ing our home country bias any time in the near future.

Finally, in the fixed income section, we reduced expo­sure to high yield and global bonds to a combined 30% weight in the portfolios, with investment grade bonds making up the remaining 70%. The combination of high yield and global bonds was previously around 35% of the total. The reduction in weight was not large because, as I wrote in the first quarter newsletter in “Bond Buyers Be­ware”, non-investment grade securities tend to fare better in a rising rate environment. Our portfolios reflect this, as the fixed income allocation outperformed the Barclay’s US Aggregate Bond Index during the recent rise in inter­est rates. That said, credit spreads in the high yield market have compressed meaningfully over the past year, limiting the long term total return opportunity. Credit spreads are now back to where they were in 2005. High yield investors should expect to earn the coupon payment and not much more.

Looking forward, we continue to research new ideas for the asset allocation portfolios. There are two main risks that concern us: rising interest rates and inflation. For a rising rate environment, we have been conducting inter­views with floating-rate managers. These securities may provide some protection in a rising rate environment because their yields reset every three months, lessening their sensitivity to rising rates. We also like these securi­ties relative to high yield bonds because they are senior secured loans. A lot of money has poured into this category over the past year, however, so we’re wary. We’ll sit on the sidelines and observe this category for now. We’re also researching “real” assets, invest­ments that provide protection during an inflationary environment. These are assets that you can physically feel and touch, such as real estate, timber and oil. By all economic measures that we currently use, inflationary pressures remain quite low, so we’re not in any great hurry. But we’re looking.