What is a reasonable time frame through which to truly judge a portfolio’s performance?
Understandably, many clients measure the performance of their portfolios over relatively short periods. It’s easier, after all, to look at how your portfolio has done over the past few years than over the past 20. It’s also easier to live in the now than to think about the 20 years ahead in your investing life.
However, the long-term investing view is a good one for most clients to have — certainly if they are years away from retirement. Additionally, the longer the investing view one has, the easier it is to measure the effect of rebalancing on a portfolio, and to see if it adds value over time.
Here we’ll take a look at the performance of a multi-asset portfolio, as well as its seven core asset classes, over 30 rolling 20-year periods. We’ll evaluate the portfolio based on its 20-year annualized returns, and also take a look at its performance based on whether or not there is annual rebalancing.
ROLLING PERFORMANCE
Let’s focus first on the rolling performance of the multi-asset portfolio’s different ingredients. Shown in the chart “The rolling twenties” are the rolling 20-year returns of large-cap U.S. stock, small-cap U.S. stock, non-U.S. stock, U.S. bonds, U.S. cash, real estate and commodities.
Large-cap U.S. stock was represented by the S&P 500, while the performance of small caps was measured by the Ibbotson Small Companies index from 1970-1978 and the Russell 2000 from 1979 to 2018. The performance of foreign equities was represented by the Morgan Stanley Capital International EAFE index. U.S. bonds were represented by the Ibbotson Intermediate Term Bond index from 1970 to 1975, and the Barclays Capital Aggregate Bond index from 1976 to 2018.
Cash was represented by 3-month Treasury bills. Real estate was measured by using the annual returns of the NAREIT index from 1970 to 1977, and the Dow Jones US Select REIT Index from 1978 to 2018 (prior to April 2009, it was known as the Dow Jones Wilshire REIT index). Finally, commodities were represented by the Goldman Sachs Commodities index.
The far-right column of “The rolling twenties” shows the rolling 20-year returns of a portfolio including all seven asset classes in equal allocations. The multi-asset portfolio was rebalanced at the end of each year over all the rolling 20-year periods.
As noted by the yellow highlighting, individual asset classes had distinct periods during which they generated the best rolling 20-year returns.
Commodities dominated during the first three periods (1970-1989, 1971-1990 and 1972-1991). Performance leadership shifted to small caps in the 20-year period starting in 1973, and stayed there for five consecutive 20-year periods. Then, large caps took over for the next 12 rolling 20-year periods. In the 10 most recent 20-year periods, real estate has been the dominant asset class.
Equally interesting is the general decline in 20-year performance for each asset class, as well as the multi-asset portfolio, in the more recent 20-year rolling periods. The most recent 20-year performance (1999-2018) is the lowest over this 49-year period for four of the individual asset classes, as well as the total portfolio. Moreover, the most recent 20-year performance for most asset classes is considerably below its average 20-year rolling performance. The only exception is real estate, which is “only” around 200 bps below its average 20-year rolling return.
You’ll also see the highest 20-year return for each asset class and the multi-asset portfolio highlighted in blue font. It’s worth noting that the highest 20-year returns all occurred several decades ago. Finally, it’s noteworthy that the average 20-year rolling return is higher — in every case — than the 49-year annualized return.
What should advisors tell their clients about these findings? Very simply this: Performance of individual asset classes and multi-asset portfolios is cyclical. Don’t overreact to cyclical realities. Stay the course. If you’re not diversified, get diversified.
REBALANCING REVIEW
Let’s now turn to the issue of rebalancing. Rebalancing a portfolio keeps the various ingredients at their assigned allocations as the years pass. Let’s now consider how rebalancing has played out over the long haul.
In the chart "To rebalance or not to rebalance" we examine the performance of the seven-asset portfolio where each asset class was equally weighted with an allocation of 14.29%. One version of the portfolio was never rebalanced and the other version was rebalanced at the end of each year.
The big question: Did rebalancing produce a performance advantage?
To determine this, I measured the performance of both portfolios over each of the 30 rolling 20-year periods, to control for time-period bias. Taxation was not considered, which implies that the accounts in this analysis were tax-sheltered.
The first 20-year period was from Jan. 1, 1970, to Dec. 31, 1989. A total of $7,000 was invested into each portfolio at the start of every year (representing $1,000 into each of the seven asset classes). The ending value of the non-rebalanced portfolio was $780,051, compared to $790,594 for the annually rebalanced portfolio. Thus, the rebalanced portfolio saw an advantage of $10,543. Over the next rolling 20-year period (1971-1990), annual rebalancing produced a $37,109 advantage over the non-rebalanced portfolio.
We observe a rebalancing advantage in 70% of the 30 rolling 20-year periods. The average rebalancing advantage was $11,910. The largest rebalancing advantage was $37,109, over the period from 1971 to 1990. The largest rebalancing disadvantage of -$23,988 occurred from 1980 to 1999. So, during that time, the portfolio was $23,988 better off when it wasn’t annually rebalanced.
It’s instructive to note that two of the nine periods in which rebalancing produced the largest disadvantage (1979-1998 and 1980-1999) were periods that ended at the high point of the tech bubble. When an asset class (large-cap equites in this case) is experiencing unusually large returns year after year, one might choose not to rebalance but instead to let the asset “run.” By not rebalancing, the gains in the “running” asset class are allowed to compound on themselves, thus producing a better outcome — for a while.
It’s a logical idea to 'let winners run' by not rebalancing — but it’s shortsighted.
The non-rebalanced portfolio allowed the percentage allocation in surging large caps to escalate during the late 1990s. Thus, the non-rebalanced portfolio outperformed the rebalanced portfolio.
But all that changed in 2000, 2001 and 2002, when the tech bubble burst and the performance of equities crumbled. The S&P 500 had returns of -9.1% in 2000, -11.89% in 2001 and -22.10% in 2002. Foreign stock and small caps also sank. These negative returns were applied to large allocations in the non-rebalanced portfolio. Big ouch.
Witness the large rebalancing advantages that immediately followed the 1980-1999 rolling period. The 1981-2000 rolling period had a rebalancing advantage of over $16,000, followed by $21,017 over the period from 1982 to 2001 and $33,212 from 1983 to 2002.
It’s a logical idea to let winners run by not rebalancing — but it’s shortsighted. The problem comes when the outperforming asset class suffers a correction (which they all do) and their large losses are experienced by a larger-than-originally-specified portion of the portfolio. Moreover, how is anyone capable of knowing how long an asset classes will continue on a hot streak? For these two reasons, rebalancing each year is advisable.
NATURAL CYCLES OF PERFORMANCE
This study reveals that even over 20-year rolling time periods we observe material fluctuations in the performance of every major asset class. Clearly, there will be even greater performance variation over shorter time periods. Thus, it’s important that advisors and clients stick to a long-run investing plan and don’t overreact to the natural cycles of asset class performance.
Rebalancing makes good use of performance weakness by buying more of that asset — not selling out during periods of weakness. A success rate of 70% is compelling. But it’s important to remember that rebalancing needs time to demonstrate a benefit. Twenty years might be a good starting point.
