A new rebalancing methodology to reduce risk and increase dollar cost averaging in defined contribution plans

By Neil Plein
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A PDF Version of this White Paper is available here

Summary of findings

This study was conducted over a 3 year period to determine whether or not the frequency of portfolio rebalancing in defined contribution plans had an effect on risk mitigation. A professionally constructed model portfolio designed to exist on the efficient frontier was used and It was hypothesized that that the higher the frequency of rebalancing the greater the degree of risk mitigation.

As methods of rebalancing have two primary components, cash flow management (plan contributions) and rebalance frequency; the traditional methods studied use plan contributions as being passively invested based on an originally designed asset allocation, followed by rebalancing (highest to lowest) at either quarterly, semi-annual or annual intervals.

These three methods were compared to a fourth method, that of the Self Aligning Portfolios™ methodology (U.S. Pat. 8,060,428) developed by Invest n Retire® (INR); which uses cash flows at each payroll period to bring a portfolio either wholly or partially back into balance followed by a quarterly rebalance as necessary. This method served as the highest frequency rebalancing method considered.

The data strongly supported the hypothesis, that the higher the rebalancing frequency, the higher the degree of risk mitigation (evidenced through higher returns and fewer losses when compared to traditional passive cash flow management and reduced rebalancing frequencies).

Furthermore, at the conclusion of the study, the Self Aligning Portfolios™ had generated larger asset positions than comparative methods; the result of utilizing cash flows at each contribution period to purchase more shares of underweighted positions and either few or no shares in over weighted positions.

Introduction

In 1952 Harry Markowitz introduced Modern Portfolio Theory, which uses asset allocation to maximize returns from a portfolio exposed to a specific risk level. A portfolio which achieves this is said to exist at the ideal (tangency) position of the “efficient frontier,” as displayed in the famous Markowitz ‘bullet.”

Figure 1: The Markowitz bullet

In the above example, the red dot represents a portfolio that is ideally situated on the efficient frontier. The portfolio is the sum total of all the yellow dots, which represent the particular investments contained in the portfolio and their respective weightings.

This hypothetical “efficient” portfolio can easily depart from its ideal position on the efficient frontier. Over time, market forces can affect the weightings of positions within the portfolio, causing it to move to a position of moderately higher return exposure accompanied by substantially increased risk exposure (Fig. 2 Point A) or vice versa, moderately lower risk exposure with substantially reduced return potential (Fig. 2 Point B).

Figure 2: Departure of a portfolio from its ideal position on the efficient frontier

These market forces can be magnified to some extent by the traditional method of investing cash flows, which divide up plan contributions and invest them solely on the initial design of the portfolio. This further drives the portfolio away from its initial (efficient) design and introduces the necessity of periodic rebalancing.

Traditionally, these two combined forces (market and cash flow) are responsible for moving a portfolio away from its ideal position on the efficient frontier; as both produce a negative effect under the tenets of Modern Portfolio Theory. Yet, of these two forces, only market forces are beyond control, cash flow forces are not.

This study hypothesizes that utilizing plan cash flows as a mechanism to increase portfolio rebalance frequency will effectively reduce a portfolio’s movement away from its ideal position on the efficient frontier and hence, mitigate its risk as a result of the increased rebalancing frequency. This method, developed by Invest n Retire®, is known as Self Aligning Portfolios™ (SAP) technology.

Further, by utilizing plan cash flows for rebalancing purposes through the SAP technology, more shares in underweighted positions should be purchased and either few or no shares of overweighed positions should be purchased; resulting in greater dollar cost averaging effect compared to traditional cash flow management and rebalancing methods (quarterly, semi-annually and annually).

Data from an actual retirement plan participant was used over this study’s 3 year period, which extended from 2009 to 2011.

Traditional Methods of cash flow use and rebalancing

Keeping a portfolio in line with its intended design is important, that is why rebalancing occurs in nearly every type of investment portfolio.

In a defined contribution plan, when an employee contributes money to his or her retirement plan, there is an event where money is going into the plan. Currently, the process works in this way; say you’re starting a new retirement plan on January 1st. Hypothetically, your model portfolio is built with specific risk/reward characteristics, so your money is allocated across 2 funds, Fund A and Fund B, each receiving 50% of the money you put into the plan, $100 each payroll period. Your first contribution to the plan looks like this:

Figure 3: Initial Balance

The next time you put money into the plan will be January 15th. Hypothetically, between January 1st and January 15th say the value of Fund A tripled.

Figure 4: Changing values as a result of market conditions between Jan. 1 and Jan. 15

On January 15th, before you make a contribution to the plan, your portfolio is invested 75% in Fund A and 25% in Fund B. Now your $100 going into the plan, split 50/50 has this effect:

Figure 5: January 15th payroll contribution effect

Although your portfolio design is intended to limit your exposure to Fund A and Fund B to 50% each, market forces and additional plan contributions to the plan put your portfolio in a position of being inconsistent with its risk reward characteristics (off of its optimal position on the efficient frontier). For this reason, rebalancing is necessary, again, typically taking place quarterly, semi-annually or annually.

The Concept of Self Aligning Portfolios

Think about the example above. Look back at the January 15th contribution again; the contribution is going into a portfolio with the following conditions:

Figure 6: Changing values as a result of market conditions between Jan. 1 and Jan. 15

The technology of Self-Aligning Portfolios™ (SAP) intelligently allocates the contribution going into the plan by first valuing the portfolio and then determining how the money should be allocated to bring the portfolio back to or as close to being balanced as possible. Rather than splitting the contribution money up 50/50 and continuing to allow the portfolio to remain out of balance with its intended risk/reward characteristics, the portfolio is first valued, which shows that Fund A has tripled; so then the entire contribution of $100 will be invested into Fund B.

Figure 7: January 15th payroll contribution effect using Self-Aligning Portfolios 

Data basis for the study

A retirement plan participant was selected at random from a plan on the INR platform. The only qualification for consideration was that the participant had been enrolled in the plan for more than 3 years.

The participant’s information was then used for the study, including:

Starting balance
Asset allocation
Contribution dates
Contribution amounts
Pretax
Match
Roth
Trade execution prices
Rebalancing dates
Dividend rates
Dividend dates
Plan expenses
Investment changes

As the participant was enrolled in a plan utilizing the SAP technology, this information would serve as an independent variable. The dependent variables would be the comparative outcomes resulting from the replication of the participant’s information under methods of rebalancing which occurred quarterly, semi-annually and annually.

As trades on SAP technology occur intra-day, the execution prices also served as the execution prices for the comparative methods, collectively referred to as hypothetical rebalancing methods (HRM’s). If a trade did not occur for a security under the SAP technology, the execution price for the HRM’s was taken from end-of-day Net Asset Value (NAV) pricing supplied by Morningstar™. An example of this difference can be seen below when comparing the SAP portfolio during at a contribution period to a quarterly HRM at the same period (note that no purchases are made in SAP to positions valued and deemed to be over weighted- AGG, DFEMX, DISVX and DFSVX):

Figure 8: SAP Portfolio (left) compared to quarterly HRM portfolio (right)

116 events like the above (Figure 8) provided the data points for each rebalancing frequency, resulting in a total of over 464 points of measurement.

Dividend rates were also replicated, if an actual dividend was paid for a security under the SAP technology, it was paid at the same rate for HRM’s. Additionally, as actual plan expenses occurred for the participant under the SAP technology as a percentage of assets, the same rate was applied to account for plan expenses for the HRM’s based on their asset levels.

During the 3 year study period, several investments were replaced and portfolio asset weightings adjusted. These instances include:

-          10/5/2009: Rebalance, BND replaces AGG, DISVX and VGK removed, portfolio weightings changed.

-          2/24/2010: VWO and VNQ added, portfolio weightings changed.

As the effects of these changes could be observed under the SAP technology, they were implemented the same way for the HRM’s; even if the change occurred away from a rebalancing event, it was assumed that if an investment were dropped from a plan and replaced by another, the assets would be mapped to the new investment.

Portfolio valuations were taken at the end of each month before dividends. In order to accurately compare the performance between the SAP technology and the HRM’s given the frequency of these valuation periods, the Modified Dietz Method of performance reporting was used for comparative purposes.

Study Results

The 3 year study resulted in data which strongly supported the hypothesis. Through its use of cash flows to increase rebalance frequency, the SAP technology demonstrated an ability to mitigate risk at a higher degree than the comparative HRM’s; evidenced through the SAP technology achieving higher returns (2009, 2010 and 36mo ROR) and fewer losses (2011) at each measure.

Figure 9: Annual and total returns

By taking the total number of shares for each position in the SAP technology and HRM’s, then ascribing a weighting to each asset’s total proportionate with allocation weighting for the portfolio, the effect of increased dollar cost averaging as a function of rebalance frequency can be observed and cash flow use can be observed.

Figure 10: Dollar cost averaging calculations presented by asset allocation weighting 

Conclusion

Modern Portfolio Theory defines the nature of an efficient investment model; that which optimally balances risk and reward. Such a design occupies a particular location on the efficient frontier and any movement away from that location results in an increased risk, such as moderately higher return (and loss) exposure accompanied by substantially increased risk exposure. This risk emerges over time due to market and cash flow forces. Mitigating this risk is accomplished through mitigating the degree of movement for a portfolio away from its ideal position on the efficient frontier.

This study hypothesized that increasing rebalancing frequency through the use of cash flows (SAP) would result in a greater degree of risk mitigation than rebalancing methods which did not use cash flows and instead rebalanced only at quarterly, semi-annual or annual intervals.

To test this hypothesis, 3 years of actual participant data was used form a plan with SAP technology. Over the 3 year period, there were 116 events which provided data points. These events were then replicated in rebalancing methods not utilizing cash flows and only rebalancing at either quarterly, semi-annual or annual intervals; resulting in 464 total points of measure between the four methods of cash flow use and rebalancing.

The data supported the hypothesis that the SAP technology successfully mitigated risk to a higher degree than the other 3 methods compared.  Additionally, the SAP technology resulted in a greater dollar cost averaging effect, evidenced through larger position ownership at the end of the period.

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About Darwin Abrahamson
Darwin Abrahamson founded Invest n Retire‚ LLC (INR) in 2004. Since 1982 Darwin has worked with fiduciaries and pension administrators of qualified tax-deferred retirement plans. Darwin has written articles for several financial publications; including Financial Planning Magazine‚ Financial Advisors Magazine, and the Journal of Indexes. His articles have been syndicated by Universal Press Syndicate. Darwin wrote an article‚ Avoiding Redemption Fees in 401(k) Plans‚ for Financial Advisors Magazine in 2005. In response to a white paper published in the Journal of Indexes‚ June 2008‚ Darwin wrote a rebuttal‚ Debunking the Myth That ETFs Have No Place in 401(k)s.

One Response to A new rebalancing methodology to reduce risk and increase dollar cost averaging in defined contribution plans

  1. Carol says:

    The WEB version is beautiful! Carol

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