Is this a time for rebalancing?

To rebalance or not to rebalance, that is the agonizing question facing investment fiduciaries today. The sharp collapse of stock prices has left many underweight equities vis-a-vis bonds. Even if over the long term pension funds have outperformed their long-term strategic benchmark, it’s cold comfort when many pensions and endowments are down 20% or more just in the past few months. There are spending requirements and liabilities to pay, now and later.

Most large public investors tend to stick to their long-term plan, perhaps hugging the benchmark for job security. Recall John Maynard Keynes’ admonition that “worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.”

That’s why the famous 1986 Brinson, Hood and Beebower article in the Financial Analysts Journal says that more than 90% of return is explained by the strategic asset allocation. If you don’t make any sector bets and stay close to the benchmark weights, of course the initial allocation will explain much of your performance over time.

I think that view is a bit too cynical. Passive rebalancing is a mechanical and disciplined approach that results in selling your winners and buying assets that have underperformed to get back to the strategic allocation. It takes the emotion out of investing and places the strategic allocation front and center as the right long-term (and short-term) asset mix. It is consistent with a belief in mean reversion of market returns and eschews market timing. If your circumstances and long-term market expectations haven’t changed, this makes a lot of sense.

There are practical limitations that can slow rebalancing, including disrupting asset managers and lockups that prevent ready access to cash. These days, illiquidity in the bond market may be a constraint on selling bonds to buy equities. In fact, corporate bonds are trading at Great Depression levels and might be a better value than stocks now. But that gets us into the realm of tactical asset allocation (OK, market timing).

A consultant recently said she would not rebalance now because the outlook was so unclear. In a previous life as a trader, she was taught to sit on her hands at times like this. But to me, sitting on your hands means returning to the allocation of the long-term strategic portfolio. Otherwise, you are making an active tactical bet. Behavioral finance tells us to be careful of this status quo bias.

The rebalancing decision depends on what discretion is given to the CIO and the role of the board of trustees. If automatic rebalancing is the mantra, then you need do it or call a special board meeting to change the strategic allocation. Otherwise, the CIO should be held accountable for tactical tilts by measuring actual performance vs. the long-term benchmark. I get the impression that there is some confusion about responsibilities here, yet it seems perfectly clear to me. It’s probably in the investment policy statement.

My preference is to give the CIO latitude to make controlled tactical bets because I believe that the markets, while mainly efficient, can be mispriced from time to time. And I prefer to hold one person accountable as opposed to a committee (or group) where shared blame and other behavioral factors can impair timely short-term decision-making and sometimes result in wishy-washy compromise.

Analysts say we are in the midst of the 1,000-year flood in the financial markets. Yet we seem to have these floods every 10 years. There are black swans popping up everywhere, and they are of the negative strain. (I’m told black swans can have positive consequences although I’ve never seen one.)

The need for downside protection has suddenly become in vogue. Some managers are gearing up to provide tail risk products (what marketing is now calling “solutions”). Our intern pretty much nailed it when he opined, “Isn’t that like buying insurance after the accident has happened?” He priced a put option from one year ago when the S&P was 1,485 (gulp, it was 832.23 as of Feb. 4). An option (20% out of the money) cost less than 1% given 20% market volatility. In today’s volatile market (60% volatility), it would cost 13%. Hedging risk is very expensive. Maybe risk managers are fighting the last war.

Is protection against low frequency, high severity events, really necessary? If you are relying on investment earnings for 35% of your budget, then the answer would seem to be yes. In fact, it would seem prudent to put aside some reserves to tap when the big one hits. That’s what catastrophe insurance companies do.

We are likely to see a number of changes after the financial tsunami of 2008. Simple is in, complexity is out.

Portable-alpha strategies will take a hit. The replication strategy of cash on steroids plus index futures plus counterparty risk has failed to come close to matching, let alone beating, the underlying asset class. It is not the same as old-fashioned stock picking. It never was.

Often sold as an alternative to cash, hedge funds have woefully underperformed their LIBOR-plus-400 basis points benchmark. Worse, headlines speak of an alleged massive Ponzi scheme by hedge fund manager Bernard Madoff. Investors may have lost billions. Expect more transparency, regulation and better (much better) due diligence in the hedge fund world going forward.

My hope is that liability-driven investment strategies will catch on even more. For many investors, managing was never about beating your peers or even some ginned-up market benchmark, but having money on hand when it was needed.

One of the biggest frustrations asset managers have this year is that bonds have not been the anchor in the wind that they are supposed to be. Stability via diversification has proven elusive in a crisis once again. I don’t have an answer for this one. I feel your pain.

The markets will eventually recover in spite of the recent economic and market volatility. It feels as if we are on an old rickety roller coaster almost jumping the tracks from time to time. We’ll get there, but it is nerve wracking.

It could get worse, but the odds would seem to finally favor the investor. We will no doubt have less leverage and more government intervention going forward. I can’t believe that it will have major negative impact on long-run asset returns. In fact, given the magnitude of the sell-off, expected returns have gone up, at least over the intermediate term. So, I’d definitely rebalance right now and look for an opportunity to tilt toward risky assets as the year unfolds.

Jeff Pantages is chief investment officer, Alaska Permanent Capital Management Co., Anchorage.