ETF Country Plus Strategy Insights: Rebalancing (Part 3)

James Kimball | February 2, 2015

There were no position changes in the Country models this week. China and India, which were both looking strong heading into this week cracked under the broader market pressure. Losses in these two ETFs were offset by gains in TMF in the basic model, but the Stops & Targets didn’t fare as well without that buffer. The performance was still in-line with the benchmark and on the year, both models are still matching or outperforming the benchmark.

The broader market had a rough week (and month), prompted by still more concerns about global slowdowns and deflation and weakness in commodity prices. The SPY closed near the bottom end of its recent trading range.

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This Week’s Strategy Lesson: Rebalancing (Part 3)

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I’m going to preface this week’s article with this note to anyone who has joined us in the last couple months. Rebalancing is probably one of the more complicated aspects of following this model, and it is not something you will have to deal with for some time. I encourage you to read this segment of articles, but do not be intimidated by them. When your portfolio gets to the point of needing rebalancing we’ll be here to help.

And if you have joined us in the last week or so I encourage you to review the last two articles (links to them can be found at the bottom of this same article found in the “Strategy Insights” section of your member area”)

The last couple weeks we have been discussing the topic of rebalancing a portfolio. In the first part of this series we covered some of the core concepts of why you should rebalance, including showing how it can affect your performance, diversification, and risk profile.

Last week we looked at the process for rebalancing a simple three ETF portfolio. This week we move onto how to tackle a Stops & Targets portfolio or one with significantly more positions.

We should stress again that depending on your own money management style and the performance of your holdings, rebalancing does not need to be a frequent occurrence.

For the ETF portfolios, one of our money management rules is that when we rotate out of a position we enter the new position with the same amount of capital as the one we just closed out. This effectively divides your portfolio into separate pools of capital. This is necessary since we don’t know how when we will get into or exit trades and we want to have the ability to have all our capital continually invested.

If you were following a higher frequency trading system that uses consistent sizing across all positions, you don’t really run into a rebalancing problem. But once you start running trades like a portfolio you will encounter some situations where a single position starts to dominate your whole portfolio as far as risk and performance.

The ETF Complete Portfolio holdings are a good way for us to walk through rebalancing a larger sophisticated portfolio that includes cash from profit taking and being stopped out. The Complete portfolio holds the Stops & Targets holdings for each of the three models (Sector, Country, and Global Macro).

The image below lists the three models and systematically goes through the information you will need to see what a freshly rebalanced portfolio would look like.

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The first line within the box shows you the three holdings for each model. You will notice the Sector Stops & Targets model is currently in cash for two of the positions and the other position, DRN, has already reached its first profit target, so we are only in 2/3rds (66%) of that position (Note that the Basic version of the model is in all three positions).

The basic process of balancing can be done by first figuring out what a balanced portfolio would be holding given the amount of capital you have allocated to your model. And then calculating what that balance portfolio would be holding for its positions. From there you can see how your portfolio needs to be adjusted. I’ll step you through it.

For ease of illustration, I have assumed you have $9,000 allocated to each model ($27,000 total). The “Cash Allocation” lines show the total allocation for each model and that translates to $3,000 for each position in each model.

The lower 4 lines show the correct current allocation of shares and cash for our sample portfolio to be consistent with the model. You can see that for a freshly rebalanced portfolio with approximately $3,000 in each position, currently you would have ~20 shares of DRN and ~$1,020 of that $3,000 would be sitting in cash.

Likewise, you can read left-to-right and see the cash or number of shares for each position in this balanced portfolio. To balance your own portfolio (assuming $9,000 invested in each model), all you would have to do is buy or sell shares until the totals you hold match the totals in the above image.

This seems pretty easy, and once you figure out the allocation, the information flows quickly from there. One complicated part is determining your current equity. If you are just getting started, it is easy to determine the amount of capital you are going to invest. But if you have been trading the model for several months and you want to take advantage of compounding and our recommended money management style, you have to track your trades to know your current allocation (which will grow or shrink as the model gains or losses on trades).

With many portfolios, particularly if you aren’t allocating a significant amount of capital or if you are good with numbers, you can use rough estimates or eyeball your holdings and tell if and how they should be balanced.

The ETF model portfolios are rebalanced twice a year, in January and July. We have found this to be the right frequency. It gives trades plenty of time to run without letting the portfolio get too out-of-balance. You can decide if you want to follow a similar calendar-based rebalance or just keep an eye on your holdings and rebalance when you determine there is sufficient cause.

As with any trading decision, there can be positives and negatives. It might be the case that when you rebalance it lowers your capital in that one position that happens to do really well over the next period, or likewise the opposite can happen. Without being able to know the future, having a balanced, diversified portfolio is one the best ways to avoid outsized losses from a trade.

The Current Condition of the Model

For the country model, we are in FXI, IFN, and TMF. IFN is about a $1.50 away from hitting its final target in the Stops & Targets model. FXI showed some weakness this week coming hard off its impressive new three-year high closes last week.

Stay tuned to daily updates for any position changes.

Here is a summary of the weekly performance of all the ETFs that the strategy monitors:

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Best wishes for your trading,

James Kimball
Trader & Analyst
MarketGauge