TMG Rebalancing Philosophy: Recent Volatility, and How We Help Add Value Through a Granular, Tolerance-Band Approach

Adam Recker, CFA, CFP® & Michael Furla, CFA, CFP®

The U.S. Federal Reserve (Fed) hiked interest rates by 0.25% in March with additional plans to rapidly wind down its $9 trillion balance sheet. Additional rate hikes are planned for 2022 with 0.5% rate hikes on the table. U.S. and international equity markets reached correction territory during the first quarter due to various headwinds, including elevated inflation, globally synchronized central bank tightening, the Russia/Ukraine war, and supply chain bottlenecks. Bonds posted their worst quarterly return since 1980 due to a rapid rise in yields and the aforementioned headwinds. During such periods of market volatility, The Mather Group, LLC (TMG) deploys various strategies to add value, including tax loss harvesting, asset class rebalancing, and accelerated tax strategies, when appropriate.

 

As many are aware, there has been market volatility, driven by the Federal Reserve’s ongoing decision to raise interest rates, and last week communicating that they are resolved to continue raising them if needed, to tame inflation. While volatility is expected due to these actions, we want to focus on the long term as central bank interest hikes will stop when inflation is controlled, and historically have quickly transitioned to rate cuts. In fact, we have seen some recent moderation in inflation, and if history is a guide, in the U.S it shows that after each of the last rate hikes by the Fed, the S&P 500 Index posted, on average, a gain of almost 15% over the next 12 months since 1970, with gains in eight of the 11 one-year periods following each peak in the federal funds rate.[i]

While our daily focus is on the markets and serving our clients, our clients often lead busy lives, whether due to the demands of careers, family obligations, or enjoying their retirements. We believe that we offer a multitude of services that provide value across the financial planning, tax, and investment spectrum, and we recognize that sometimes it is difficult to remember how or why we provide certain services. One topic that we find helpful to refresh on a yearly basis is an overview of our portfolio construction and rebalancing philosophies.

As a reminder, at The Mather Group, LLC (TMG ), we primarily follow an index-based investing approach. We prefer to invest in low-cost indexes in a risk-appropriate and diversified manner, because our studies and others show that many active managers (stock-pickers, market-timers, etc.) tend to underperform their appropriate benchmark over the long run, especially when taking expenses and taxes into consideration.[ii] While we invest in index funds, we are not passive investors, as we strive to use our investment and operational processes to help drive higher after-tax returns for clients, while reducing risk along the way.

As an example, we build our portfolios in a manner that is aligned with diversified global market exposures but use a mix of index funds to get this exposure in a more granular manner. We believe that this is better than using just one or two diversified funds, as our structure creates more opportunities and provides flexibility.

While many are familiar with rebalancing between stocks and bonds, after reviewing a multitude of studies[iii], [iv], [v], [vi] and performing our own, we believe that a more granular rebalancing approach adds greater value over the long run. This is because we have the additional ability to rebalance between factors (growth and value), regions (U.S. and International), and company size (large and small) as the market fluctuates and investors take more extreme positioning or chase performance (perhaps by only investing in U.S. growth stocks).

We believe using granular funds that perform differently from each other (like a U.S. small value stock exchange-traded fund (ETF) or an international stock ETF, among others, as opposed to just a global fund) gives us an advantage— it allows us to be tactical in choosing which funds to hold in specific accounts. This concept, called “asset location,” enables us to put investments in certain accounts to try to optimize tax efficiency and investment returns. This granularity also gives us more opportunities to harvest tax losses in taxable accounts and also allows for more rebalancing opportunities.

In addition to the granular portfolio construction, the rebalancing process matters. Historically, many investors have followed a calendar-based approach (monthly, quarterly, annually, etc.), but we follow a tolerance-band approach. We believe the tolerance-band approach allows positions to fluctuate within a risk-appropriate range, only triggering a rebalance when we believe that activity will add value. Candidly, a mass rebalance is expected to be relatively rare for several reasons.

While we have experienced recent market volatility, it has not brought many significant rebalancing opportunities because both global stocks and bonds fell in value during the pullbacks. Fortunately, an environment where all asset classes fall is rare, and in a more normal environment, there would be more rebalancing opportunities. An example was the COVID-19 selloff in April 2020, when bonds were up 2% and US equities were down 23%. Furthermore, in a decade like the 2000s, international stocks performed better than U.S. stocks for a prolonged period, which would have provided an opportunity to buy U.S. stocks during a rebalance.

While less noticeable, many of our clients undergo small rebalances that course-correct the portfolio risk and allocation throughout a given year. For example, rebalances often take place when our team conducts Roth conversions, tax-loss harvesting, or portfolio adjustments. In addition, anytime cash is raised for a distribution, overweight positions are trimmed. Periodically, dividends and income are generated from investments, and those funds are reinvested into underweight positions in the portfolio. Beyond those activities, most rebalances continue to be triggered by persistent outperformance of one asset class relative to another.

Most importantly, as long as the portfolios remain in tolerance and risk-appropriate, a lack of activity should not be mistaken for a lack of value creation, as greater activity for the sake of activity may not be additive to performance or reduce risk.

Please let your trusted TMG wealth advisor know if you have any questions.

[i] The End of Rate Hikes?

[ii] S&P Indices Versus Active (SPIVA) Scorecard

[iii] FQ Perspective: Rebalancing  a Global Policy Benchmark: How to Profit from Necessity February 2001

[iv] Opportunistic Rebalancing: A New Paradigm for Wealth Managers

[v] Portfolio Rebalancing Research: Momentum and Tolerance Bands

[vi] The Behavior of Individual Investors

The Mather Group, LLC (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov, or on the firm’s website at www.themathergroup.com. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG’s research and professional experience and are expressed as of the publishing date of this communication. All return figures and charts shown are for illustrative purposes only. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice. Investing involves some level of risk. Past performance does not guarantee future results.

An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Please feel free to contact us for additional information on any indices mentioned.

Indexes

  • Standard & Poor's (S&P) 500 - A stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.

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