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Our Interview with Phil DeMuth and Ben Stein
April 29. 2008
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Your data shows that rebalancing leads to portfolios with lower risk and lower returns, and that the best way to avoid this effect is to set a tolerance that triggers the rebalancing.  What is the underlying cause of this phenomenon?  What is your bottom line on this – what rebalancing strategy do you use in your practice?

DeMuth: Our view is that frequent rebalancing does not rebalance risk vs. returns efficiently.

Let’s say you rebalance daily.  Over the past day, there have been movements in the market.  Some of these movements reflect an accurate re-pricing of assets.  But mixed in with this signal is also a lot of noise: some of these assets have been re-priced too far in one direction or another.  If we rebalance every day, never mind transaction costs, we are going to be shuffling a lot of noise into the mix along with the signal.

Take the other extreme: let’s say we never rebalance.  Ten years out, it is pretty clear what the long-term secular trends have been.  If we rebalance now, we are folding in almost all signal and very little noise.  The problem is, our portfolio may have wandered far from its original specs and become riskier along the way.

Between these two points is an efficient frontier.  For complex, multi-asset portfolios, we think that tolerance-based rebalancing adds value when a portfolio gets about 20 percent out of alignment.  I take a fairly parsimonious approach to rebalancing, only rebalancing outliers as needed.  But this is an empirical question and more research is needed.

One of the interesting topics you discuss is the role of fixed income in a portfolio.  You suggest substituting low-volatility stocks for bonds as a way to reduce risk.  Does fixed income have any role in the portfolios in your practice, and how do you choose the “right” stocks for this purpose?

DeMuth:  Portfolio theory suggests that the role of fixed income – other than when it is used to provide, well, fixed income – is to dampen portfolio volatility.  So I use a diversified bond portfolio to serve this purpose.  The trade-off is that historically bond returns are much lower than equity returns. 

One way out of this dilemma is to use low-volatility equities to give us the best of both worlds: more bond-like lower volatility but with more equity-like higher returns.  We screen for stocks with a low 3-year standard deviation.  The caveat is that whenever you are selecting for extreme scores on a criterion, you are going to get regression to the mean.  A portfolio overweighted with low volatility stocks will almost certainly be higher in volatility going forward.  Nevertheless, the solution is directionally correct.  If you are running a standard 60/40 stock/bond portfolio, you won’t be able to run a 100 percent low-volatility stock portfolio to the same effect. But you might be able to go 70/30 and get higher projected returns for roughly the same level of risk you had before.  In general, the stocks that work best as market index portfolio diversifiers are those that are low beta, low r-squared, and/or low volatility.

You researched the holdings of Berkshire Hathaway to determine the level of diversification Warren Buffett has in his portfolio.  Can you summarize your methodology and findings?

DeMuth:  There is a division between academic advocates of Modern Portfolio Theory on the one hand, and seasoned value investors like Buffett and Munger on the other.  Each side tends to be dismissive of the other.  What we did was put Berkshire Hathaway’s holdings into the Monte Carlo simulator – as best we could – and take a look at BRK through the lens of MPT.  “One of the points of the book is that while owning 500 stocks in an index fund can indeed give you a diversified portfolio, it is also possible to have a well-diversified portfolio with a much smaller number of holdings.”What emerged was a remarkable squaring of the circle.  Buffett does not have a computer in his office, but he has intuitively managed to combine assets with a low inter-correlation just like a portfolio theorist would.  We suspect that this comes naturally to him, since it brings into play precisely the same diversification skills needed to successfully underwrite Berkshire Hathaway’s “big catastrophe” policies.  One of the points of the book is that while owning 500 stocks in an index fund can indeed give you a diversified portfolio, it is also possible to have a well-diversified portfolio with a much smaller number of holdings.

Has the credit crisis and current market conditions changed your views on how advisors should diversify and the level of exposure one should have to the US equity markets?

DeMuth: Not in the slightest.  The main benefit is that stocks are cheaper now than they were a year ago.  Nothing makes me happier than buying stocks for clients on days when it looks like the world is coming off the rails.  The “supercharged” portfolios have held up well in this troublesome environment, beating their benchmarks by a meaningful margin.

On the subject of the credit crisis, Ben’s column in the New York Times on March 23, 2008 argued that the critical element in the credit crisis is hedge funds that control $1.5 trillion in capital and are changing “Wall Street from a financing entity to a market manipulation entity.”  As a solution, you argue for greater transparency in hedge fund reporting and more rigorous enforcement from the SEC against schemes to defraud.  What troubles us about this theory is that it discounts the role of the collapse of the housing market.  Given that, to our knowledge, there have been no allegations of illegal trading by hedge funds, what evidence is there that hedge fund activity precipitated the credit crisis?

Stein:  It is a myth that the housing market has "collapsed." It is down, down very much indeed from its bubblicious peak, but not so far below a normalized rate pre bubble.

The trading does not need to be illegal to be incredibly disruptive and destructive. Immense short sales of the ABX and other mortgage related indices have destroyed that financing vehicle. The failures of buyers of homes have been vastly magnified by the manipulations of the short sellers. And it's not a theory. It is what happened.

[Ed. Note: The Markit ABX.HE indices track the prices of home equity asset backed securities.]

How does greater transparency solve the problem?  Should a hedge fund that is restricted to accredited investors be forced to publicly disclose its holdings?

Stein:  It does not solve the problem but it might make some rare people with a sense of shame refrain from disrupting markets.


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