How Rebalancing Frequency Affects Quality and Value investing funds

How Rebalancing Frequency Affects Quality and Value investing funds

March 19, 2015 Value Investing Research, $vlue, $voo
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(Last Updated On: January 18, 2017)

Rebalance frequency affects value and quality factors in different ways:

  • Value works better when assessed more frequently
  • Quality factors work about the same, regardless of frequently.

Other important findings:

  • Value portfolios outperform the market, historically.
  • Quality portfolios perform inline with the market, historically.

With a plethora of Quality-based ETFs and Value investing ETFs in the marketplace, we hope this research piece encourages investors to investigate the construction of the products they buy.

Our Simple Empirical Tests

First, let’s set up the experiment. We will examine all firms above the NYSE 40th percentile for market-cap (currently around $1.8 billion) on June 30th each year with the following 2 variables (akin to those used in the so-called “magic formula”):

  1. Quality = EBIT / (Net Working Capital and Net Fixed Assets)
  2. Value = EBIT/(Total Enterprise Value)

We sort securities on both variables, and select the top decile of firms. We examine 3 rebalance frequencies: 1-year, 3-years, and 5-years. The portfolios rebalanced every 3 or 5 years are formed by creating overlapping portfolios.

Quality Investing Performance

We examine 4 strategies:

  1. 12M ROC VW = Top decile of firms formed on Quality measure. Firms are held in the portfolio for 12 months. Portfolio is value-weighted.
  2. 36M ROC VW = Top decile of firms formed on Quality measure. Firms are held in the portfolio for 36 months. Portfolio is value-weighted.
  3. 60M ROC VW = Top decile of firms formed on Quality measure. Firms are held in the portfolio for 60 months. Portfolio is value-weighted.
  4. SP500 = S&P 500 Total return

Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Here are the returns (1/1/1980-12/31/2013):

quality holding period
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Two takeaways from the results:

  1. Sorting firms on quality performs similarly to an index.
  2. As the holding period increases, performs metrics improve, but the effect is marginal.

Value Investing Performance

Here we examine 4 strategies:

  1. 12M EBIT/TEV VW = Top decile of firms formed on Value measure. Firms are held in the portfolio for 12 months. Portfolio is value-weighted.
  2. 36M EBIT/TEV VW = Top decile of firms formed on Value measure. Firms are held in the portfolio for 36 months. Portfolio is value-weighted.
  3. 60M EBIT/TEV VW = Top decile of firms formed on Value measure. Firms are held in the portfolio for 60 months. Portfolio is value-weighted.
  4. SP500 = S&P 500 Total return

Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Here are the returns (1/1/1980-12/31/2013):

ebit_tev holding period
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Two takeaways from the results:

  1. Sorting firms on a value measure (EBIT/TEV) adds value over the index. The spread (with a 12-month holding period) is 400 bps higher compared to sorting firms on quality.
  2. As the holding period increases, CAGR, Sharpe and Sortino ratios decrease. This has been documented elsewhere, as value measures appear to work better when assessed more frequently.

Summary

When discussing rebalance frequency we need to consider the trade-off between transaction costs (e.g., fees, taxes) and expected performance. We examine the returns gross of fees and leave it to the reader to determine if there is a net benefit between rebalance frequency and expected performance — everyone has their own opinion on “real transaction costs”. For value, it is arguable that one can rebalance more frequently and beat the costs; for quality, rebalance frequency doesn’t seem to matter, and after costs, it therefore wouldn’t seem to help.

 


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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.


Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  • Steve

    That was interesting. Confirms the “quality is persistent” idea.

    But it also pleasantly reminded me of the tables in David Dreman’s books where value, even with longer holding periods, still “works”. I’ve thought along the lines of 12 month rebalances so long, it’s nice to remember that value works for longer than that. Impressively so, in my opinion.

    Looking at some numbers myself. If I use even a fairly hefty brokerage fee, it comes out much of a muchness after 5 years (value rebalanced annually vs held for 5 years). The increase return makes up for the cost.

    However (if I’ve done this right)…even where tax is quite generous (10%)…that then makes a significant difference…far more than I would have thought.

    The guy doing 30 stocks with 150k portfolio to start with…comes out far ahead when even small taxes are paid….with a 5 year holding period….when even small taxes are paid.

    Have I got that right?

  • Giraffe Value

    Jack Vogel

    Thanks for sharing this information, I wonder do have further findings on the merit of the frequency of portfolio re balancing for value stocks? It will be great if you can share it or any recommended read.

  • Jack Vogel, PhD

    I plan to add a new post to examine different portfolio sizes (Ns in portfolio) and holding periods for value stocks. Hopefully I will post in the next few weeks.

  • Jake

    Jack,

    Fantastic article, very thought-provoking. I too am highly interested to hear your thoughts on the best rebalancing frequency for value. I recently read Wes’ interview with Tim Melvin on Gurufocus and he stated that, tax considerations aside, quarterly rebalancing provides the best returns. This finding seems counterintuitive to me and perhaps contrary to some of the studies I have read, which show stronger outperformance annually vs. 6 months after portfolio formation. I understand the logic of always rebalancing to the cheapest stocks, but three months does not seem like enough time to capture the mean reversion of value stocks and, therefore, seems to sell winners too soon. Would love to hear your thoughts on quarterly vs. annual or even semi-annual rebalancing.

  • Jack, just had a paper so I’ll respond on his behalf…

    You get better returns with higher frequency rebalance — you can even take it to the extreme of daily returns and generate really high expected CAGRs. Of course, the frequency bonus comes at a cost — frictional + taxes. Based on our calculus, and looking through the lens of a diversified portfolio, quarterly rebalance –with a tax solution — seems to be the best risk/reward tradeoff for long-horizon active value investors.

  • Jake

    Wes,

    Thank you for such a quick response. I’m a big fan of your work and really appreciate how generous you are in sharing your valuable insights with us all.

    With that said, it’s interesting that rebalancing frequency can increase returns even daily. I guess it makes sense because with daily rebalancing you always own the cheapest stocks in the market, but I would’ve thought there needed to be some amount of time (greater than one day) for mean reversion in either operating performance or sentiment/momentum to have the stock re-rate and capture excess returns. Can you give a sense of the scale of the improvement by rebalancing quarterly vs. annually or semi-annually (absent friction costs)? Just curious if it’s 1% per annum gross or 25 bps gross and maybe not worth the extra effort for an individual investor.

  • assuming mid/large universe, high conviction (30-40 stock), focused on deep value + quality (ie quant value type algo), and no friction/taxes, annual –> semi-annual ~wash, semi-annual –> quarter 100bps, quarter –> monthly 125bps. monthly –> daily 200bps

    Also, a geeky, but important point, higher frequency enhances the ‘portfolio benefits’ when combined with momentum…if you are a bible-thumping Ben Graham believer that has no time for momentum, then this won’t matter…so ignore…

  • Jake

    Wow, thank you so much, Wes! That is an impressive amount of outperformance with quarterly vs. annual, and would clearly add up over time. I am indeed a Ben Graham devotee, which might be a short-coming because I won’t use momentum, but we all have to know our limitations! Not sure I could stick with momentum if the going got rough. Momo stocks just don’t resonate with me.

    Thanks again, I appreciate you taking the time to answer my questions.