Fairly arbitrarily, I decided to divide the portfolio into half Canadian and half US stocks. Each half consists of one individual stock and two index ETFs (one large cap ETF and one small cap ETF). The starting portfolio contains equal values of 6 different equities:
BMO – Bank of Montreal stock
XIU – iShares Canadian Large Cap ETF
XCS – iShares Canadian Small Cap ETF
BRKB – Berkshire Hathaway stock
VV – Vanguard US Large Cap ETF
VB – Vanguard US Small Cap ETF
The starting portfolio size for the experiment is $400,000 (Canadian). Because XCS began trading 2007 May 18, the experiment begins on that day with money divided equally among the 6 equities, rounded to the nearest 100 shares, except for BRKB which is rounded to the nearest share (because of its high price). Two different portfolios start this way: one is buy-and-hold and the other uses rebalancing.
The following costs are assumed:
– Trades cost $9.95 (Canadian or US depending on the shares bought or sold).
– Bid-ask spreads are two cents, except for BRKB whose spreads are one dollar.
– Currency conversion costs 0.5% on top of the exchange rate in each direction.
– Funds are in a tax-sheltered account so that no capital gains taxes are paid.
The buy-and-hold portfolio does no trading for the roughly 2.5 years from portfolio inception to the present. The other portfolio rebalances whenever the allocations drift too far from equal allocations in the 6 equities. It was surprisingly difficult to settle on a set of rules for how to do the rebalancing.
To minimize currency conversion costs, I wanted to rebalance from one Canadian equity to another or one US equity to another, where possible. I settled on the following rules to trigger a trade:
– If the total Canadian side gets outside the range 45% to 55%, then rebalance.
– If one of the Canadian equity’s proportion of the Canadian side is outside the range 33.3% plus or minus 5%, then rebalance the Canadian side. Handle the US side similarly.
For the actual rebalancing, I usually sold one overweight stock and bought one underweight stock. All trades were in multiples of 100 shares (except BRKB).
The initial portfolio size and rebalancing rules are set so that the typical trade size is about $10,000. In cases where two equities were roughly equally underweight or overweight, the buy or sell was split into two separate trades. I used my judgement rather than trying to define all the rules completely precisely.
However, I did not use any discretion in deciding when to rebalance. Whenever the portfolio was out of balance, I brought it back into balance that day.
The following chart shows how the rebalanced portfolio fared against the buy-and-hold portfolio. The red triangles mark the 8 rebalancing days that were needed over the 2.5 years.
In the end, the rebalanced portfolio won out by 3.95% (about 1.6% per year), but it wasn’t a smooth ride. For the first year and a half, rebalancing lost money. Rebalancing seemed to do a good job of exploiting the high volatility earlier this year.
Overall, this experiment doesn’t prove one way or the other whether this strategy will profit over buy-and-hold. If a basket of equities each rise at about the same average rate of a long period of time, then rebalancing can capture extra profits from the relative volatility. However, if one or more of the equities’ average growth rate is significantly lower than the others, then continually rebalancing into the underperforming equity will hurt returns.