Tuesday, January 22, 2008

Retirement Planning and the Rebalance

(Author’s note: This topic will be discussed at length in the book I am currently working on, Mutual Funds for the Utterly Confused, scheduled for a January 2009 publication. You can look for updates on the book at Mutual Funds – Explained as it is written and edited.)

There are some really smart people out there asking some really intelligent questions. Jie (Jay) Cai is one of them. He is currently Assistant Professor at Drexel University in the Department of Finance at the LeBow College of Business in Philadelphia, Pennsylvania. The work he does, while often academic, touches on some of the thoughts that the average investor might have in the course of making decisions about whether to invest in this fund or that one.

The subject of rebalancing comes up often. As investors age, they are often advised to rebalance their individual portfolios to avoid unnecessary risk or exposure for a market that might be too volatile – a suggestion seems better suited for another era. If the argument for retirement savings is based on the fact, as we discuss in the book, that we have not saved enough, then why are we acting as if we did and rebalancing our portfolios.

Mr. Cai along with another very bright fellow, Todd Houge (The University of Iowa, Henry B. Tippie College of Business, Department of Finance) took a long look at the effects of rebalancing inside an index. What they discovered might be considered enlightening.

Before we move on too far, just a brief reminder of what an index does. It is meant to extract a certain group of stocks from the market because of some type of criteria. The S&P 500, an index that is managed by the Standard and Poors Company, keeps track of the largest 500 companies based on market capitalization (or worth – shares outstanding multiplied by the price of those shares). Numerous companies do this to help investor get an idea of how the market is performing based upon just such a grouping. Only the Dow Jones Industrial Average is price-weighted.

Cai and Houge focused their efforts on the index most commonly used to track smaller sized companies, the Russell 2000. Unlike the S&P 500, which actually has 500 companies in its index and among them, the best performing rarely get removed; a small-cap index does not carry the whole of the small-cap universe. They simply can’t.

The reason is simple. Many of the companies in this type of index are too small, rarely traded and considered illiquid. If the Russell 2000 suddenly shifted its balance, all of the funds that track that index would need to purchase the new shares of the latest addition while selling the shares of the latest deletion. This could have not only a negative effect on the share price, but would, in some cases punish the funds who need to buy those companies but are unable to find an adequate amount of shares in the marketplace.

But suppose you didn’t sell the shares of the companies kicked to the proverbial curb. According to the two men, “a value-weighted portfolio of index deletions return an average of 1.52% per month compared to only 0.87% for non-new issue index additions.” This continues for the next five years although the gap does narrow somewhat.

More so in the next book than this one, I talk about how and why actively managed mutual funds choose a certain index. Some are actually trying to mimic the index while some are trading the same companies held within the index. It would be hardly fair to compare a small-cap growth fund with the largest names on Wall Street.

Here’s the problem. Index funds have their place in a retirement portfolio and, it is not inside your retirement account. (Buy the book to find out why. If you already own the book, you know why.) Actively managed funds that look to compare themselves to an index, do so to attract investors to their performance. Trouble is, too many actively managed funds do not practice a buy and hold strategy.

What Cai and Houge discovered suggests that if fund managers do try and mimic an index, they may be leaving money on the table so to speak. If they continued to hold the deleted stocks from the index, they would do better than if they had tried to follow the index too closely.

And how can you follow the Russell 2000 too closely. The index, according to the authors of the paper changes on a certain day each year and unlike many of the other indexes is not based on some “proprietary selection process.” In choosing the Russell 2000 to track, they stumbled onto an index that changes shape often and sometimes in a huge way.

“Russell replaces an average of 457 firms or nearly 23% of the index holdings each year. The annual turnover ranges,” they wrote “from a low of 309 companies in 1980 to a high of 690 companies in 2000. Since delisted securities are not replaced between reconstitution dates, the number of additions always exceeds the number of deletions.”

The person focused on retirement planning can draw two conclusions from this. First, not all indexes are created equal, necessarily do as you would suspect and might be more active than you would imagine.

The second is much simpler. Indexes often bill themselves as safe havens for investors and some might be safer than others, but the performance numbers they use in their sale material might not be as good as an actively managed fund that acts passively. Turnover may become the key statistic in determining the overall long-term strength of a mutual fund.

You can read the full paper, titled “Index Rebalancing and Long-Term Portfolio Performance” here or download the PDF

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