TARGET ALLOCATION MODEL PORTFOLIO INSIGHTS

Catching the market’s drift

Apr 21, 2022
  • Michael Gates, CFA

Managing a model portfolio with a target risk profile isn’t just a static, set it and forget it exercise. We rebalance our portfolios regularly, typically four to six times a year, and have recently moved away from calendar-driven rebalancing to more market-determined changes in portfolio weights.

This is however, not entirely driven by hot markets or shifting macro views, sometimes it can purely be a consequence of drift in the portfolios. “Drift” is movement away from the targeted weight stipulated at the last rebalance and happens in the portfolio as a function of markets that often move aggressively in either direction.

As we monitor the portfolios daily, we see this drift occur in ordinary market environments, but perhaps not to the degrees we’ve seen in recent years. At times, the nature of the market moves become so large, that it makes sense to rebalance the portfolios, not just because they’ve drifted so far from our original allocation, but also because the drift reflects a fast-moving market environment where we believe a tactical change in the portfolio is warranted. The nature of this drift can work in a couple of ways, as both March of 2020 and 2022 highlight. In this blog I’d like to explain how both rebalances came to pass, and maybe shed some light into our process if a future event unfolds that also leads to such excessive drift.

Rebalance #1: March 2020

In the first instance in March of 2020, portfolios shifted with the bond and stock allocations almost flip-flopping because one asset rallied as the other asset class fell precipitously. This was the case in the COVID-19 induced drawdown, as bonds, and longer duration bonds specifically which we held in the portfolio, rallied aggressively as the fear of the pandemic and the hit to growth and flight to safety drew broad-based selling of stocks and the buying of the safety in treasury bonds.

We examined the incremental return generated for every potential historical rebalance outside of a quarterly schedule along the dimension of equity to bond weight drift, using a simple 60/40 hypothetical model over the sample time period from 1957 to present. We found trading equity and fixed income back to target intra-quarter is a profitless strategy except when equity drift is extreme and negative. As was the case in 2020 and in our study period, the largest positive return was seen for the top 1 percentile of trading instances (negative equity drift of 6-10%). Put simply, when the drift is strongly negative (equities have drifted down from target weights) the profit and loss is strongly positive.

Rebalance #2: March 2022

Target allocation market insights

Source: BlackRock as of 3/9/22

Buys/sells refer to the underlying ETFs that were traded in the Target Allocation ETF 60/40 portfolio during the rebalance in March 2022. Portfolio drift: Amount the Target Allocation ETF 60/40 Model portfolio drifted from January 27th (date of prior rebalance) through March 9th (recent rebalance) due to movement in the market. Portfolio drift is Expressed as a %. Approximate actual trade represents the % we had to trade to reach the target allocation that was not aided by portfolio drift. Allocations are subject to change

Fast forward to today and there has been another kind of drift at work behind a rebalance. This time it is not because the stock and bond mix has moved to their furthest extremes, but because certain winning and losing positions in the portfolio have rallied an extremely disproportionate amount to the rest of the portfolio. As a result, the process of the portfolio management team and myself is to examine the drivers of these moves and confirm or deny if we believe in the merit behind them.

In this instance, the outbreak of war in Eastern Europe delivered two concurrent blows to global markets. Primarily, the hit to commodity production created a broad-based rally across the commodity complex, and a surge higher in gas prices driving energy equities. The same transmission channel delivered the second effect, which is to impinge on sentiment and production across Europe and trigger a wave of sharp cuts to earnings.

And in a nutshell, increasing exposure to energy stocks and decreasing exposure to European stocks was our last rebalance. But thanks to portfolio drift, most of the moves in those positions had already been taken care of by the market for us, and the rebalance was merely a touch-up to reflect the targets that were already largely held in portfolios. So, whilst the “Trade Delta” or amount to trade from the previous target was a meaningful number, the amount anyone following the portfolios traded in reality would have been much lower.

Hopefully you’ve gained a little insight behind the curtains here on my team, and the next time you see us trigger a rebalance amidst a volatile market – because we know there will be more – perhaps you may understand the motivation behind the moves better. Catch my drift?    

 

Michael Gates
Michael Gates, CFA, is the lead portfolio manager for Target Allocation Models in the Americas.

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