SmartMoney asks: Is your index fund broken? Good question, although here’s a better one: Is your management of asset allocation broken?

The SmartMoney story reviews an increasingly popular subject: alternative indexing methodologies. At issue is whether there’s a better way to index and earn a higher risk-adjusted return. There is, or so the article and a number of studies in recent years advise. Perhaps, although a more-productive question is how all this affects asset allocation? Yes, superior index products will improve asset allocation results, but we should be cautious before rushing to judgment.
The broader your asset allocation, the less critical the choice of any given index, assuming we’re talking of broadly diversified funds that seek to capture the lion’s share of a given beta. Getting caught up in the indexing debate about this or that benchmark is worthwhile—up to a point. But keep in mind that all the alternative indexing methodologies share a common factor: rebalancing.
One of the reasons that a given alternative benchmark beats its cap-weighted in recent years is linked with rebalancing. There’s a healthy debate about how to rebalance, and when, and there always will be. The broad lesson that flows from academic research in recent decades, which I summarize in my book (Dynamic Asset Allocation), is that opportunistically managing the asset mix is at the heart of beating the market-value-weighted benchmark of those components. True for an individual market, such as U.S. equities, and true for a multi-asset class portfolio. But the details can be messy.
But there’s an obvious place to start as a benchmark for this process. Simple year-end rebalancing of a broad asset allocation has a history of boosting performance by 50 to 100 basis points a year over the long haul, according to several studies published in The Beta Investment Report. This isn’t surprising. The notion of buying low and selling high needs no explanation. But is it a free lunch? No, of course not. What, then, is the risk?
Some of the answer (perhaps most of it, depending on the strategy) is bound up with reversion to the mean. Buying securities and/or asset classes when they’ve fallen in price on the expectation that prices will rise in the future is an assumption that mean reversion will prevail. There’s a small library of empirical studies that support the idea. In addition, there are many techniques for developing intuition about fluctuation in expected return based on mean reversion. A few tools that shed light on when it’s productive to adjust the allocation include moving averages, large changes in fundamental values (dividend yield, price-earnings ratio, yield spreads, etc.), and macroeconomic-related trends (yield curve changes, equity market/industrial production relationship, etc.).
Dynamically managing indices or asset allocation isn’t a free lunch, however. Mean reversion doesn’t unfold like clockwork. The various sources of mean reversion wax and wane through time. In some periods, the mean reversion may fade for lengthy periods. For example, in the latter half of 1990, positive momentum in growth stocks overwhelmed the value factor. As a result, rebalancing an equity portfolio didn’t do as well simply buying and holding during that stretch.
In the long run, the academic and empirical case for rebalancing in all its various forms is compelling. But sometimes waiting for the long run is asking for too much. Indeed, a number of value-oriented managers went under in the late-1990s waiting for this risk factor to reassert its historical edge.
By taking on rebalancing risk you can earn a higher return. But you have to be comfortable with a contrarian mindset. That’s easier than it sounds in real time. Were you buying in late-2008? The main source of higher expected return with rebalancing in a multi-asset class portfolio is the rebalancing process itself, assuming you own a wide mix of asset classes. Picking an alternative indexing methodology to represent one or more of those asset classes may help, although you can’t count on the edge continually. In fact, alternative indexing products can and will lag market cap products at times.
There’s also a new issue to confront: Which alternative index is superior? As the SmartMoney article reminds, some of these new benchmarks apply contrasting methodologies that presumably may deliver different results. Meanwhile, a simple equal-weighting strategy, which has beaten market-cap weighting in recent years, is primarily a play on the small-cap factor. That’s great as long as you anticipate small caps will outperform big caps, but that edge ebbs and flows at times as well.
In any case, don’t lose sight of the bigger lesson: rebalancing asset allocation is the main source of beating a passive market-cap benchmark of a broad mix of asset classes. If you’re reasonably successful with the process, the choice of benchmark design will be a secondary factor, perhaps distantly so. That doesn’t mean that we should ignore the potential for superior index design. To be fair, there are some intriguing developments on this front and they deserve careful analysis. Just don’t let this tail wag the dog.