Capitalizing on Market Volatility

On July 19, 2007, the S&P 500 Index closed at 1553. By August 15, it had dropped to 1407, a decline of almost 10% in less than a month. Obviously such a drop is unsettling, but it’s not necessarily unusual and it may be viewed as an opportunity.

Since 1990, the S&P 500 has earned a positive return in 13 of 17 calendar years, producing an overall return of 493% (including dividends). However, at least one pullback can be observed in each year, ranging from -5% in 1993 to -30% in 2002. The average drop during any given year was 12% over an average length of 60 days.

Market volatility such as this understandably creates concern among market participants. Unfortunately, this causes many individual investors to experience a degree of panic leading to emotionally driven investment decisions. The corresponding result is often the unplanned execution of a “buy high, sell low” strategy.

The evidence is compelling: efforts to time the market are rarely successful and can be destructive. Not only does it require identifying the right time to exit the market, but it also requires identifying the right time to re-enter the market. Rather than attempting this low-probability gamble, prudent investors maintain a well-diversified portfolio and adhere to a disciplined portfolio rebalancing strategy.

Portfolio rebalancing can be defined as the process of bringing the different underlying asset classes back into proper relationship following a significant change in one or more; simply stated, it is a repeated “buy low, sell high” process. The fruits of adhering to a disciplined rebalancing strategy are evident in a study conducted by Morningstar, a leading provider of independent investment research.

Morningstar evaluated two similar pools of mutual funds on the basis of both time-weighted (TWR) and dollar-weighted returns (DWR). For a given fund, the time-weighted return represents investment performance independent of investor cashflows in or out of the fund. Conversely, the dollar-weighted return incorporates the timing and magnitude of investor purchases and sales of the fund. Therefore, time-weighted returns represent the investment performance of the fund; dollar-weighted returns represent the actual experience of investors based on their decisions of when to invest in the fund.

In the study, Morningstar compared the time- and dollar-weighted returns of all no-load index funds to the returns of the Dimensional Fund Advisors (DFA) funds. The index funds and the DFA funds are similar in that they employ passive management strategies across various market segments. However, unlike the index funds, use of DFA funds is limited to advisory firms such as Truepoint who are trained on the merits of passive investing and portfolio construction theory. Consequently, investors in the DFA funds routinely follow a disciplined rebalancing strategy. This is not necessarily true for the universe of index funds as asset flows to these funds are often correlated with recent performance results as investors chase the “hot” segments of the market.

Over the ten-year period, the dollar-weighted return of all index funds available to the public was just 82% of the time-weighted return. Had investors simply bought-and-held for the period, they would have received 100% of the time-weighted return; however, the cumulative timing of investor buys and sales of the funds effectively reduced returns by over 18%.

Tellingly, the figures for the DFA funds are much better. In fact, the dollar-weighted returns of DFA funds over the same 10-year period are actually higher than their time-weighted returns suggesting advisors who use DFA funds encourage very rewarding behavior among their clients, buying out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is often the case with individual investors.

More Discipline, Higher Returns

While the collective behavior of the investing public effectively destroyed some of the value created by the market, the disciplined rebalancing strategy employed by advisors using DFA funds actually added value above and beyond what the market delivered. This value was created by capitalizing on market volatility among varied market segments in effect, capturing “buy low” opportunities. By maintaining a well-diversified portfolio and adhering to a disciplined rebalancing process, investing can become a much more rewarding, and less distressing, experience.