Diversified Allocation: Making Portfolios More Robust

This is related to the rotation of investment styles.

Growth and Value Style Rotation

The stock market has different styles, including large-cap, small-cap styles, and growth, value styles.

These styles typically do not rise and fall together, but rather take turns in the spotlight, like a relay.Here is the translation of the provided text into English:

- In 2015, the growth style demonstrated excellent performance.

- From 2016 to 2018, it was the value style that showed strong performance.

- In 2019-2020, the growth style was strong for two consecutive years, while the value style was subdued.

- From 2021 to 2022, the value style became comparatively strong again.

Rotation of Large, Mid, and Small-cap Stocks

Large-cap and small-cap stocks also exhibit similar rotational characteristics.How to distinguish between large-cap and small-cap stocks?

Typically, they are categorized based on the Shanghai-Shenzhen 300 (large-cap), CSI 500 (mid-cap), and CSI 1000 (small-cap) indices.

**Shanghai-Shenzhen 300**

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This index consists of the stocks of the 300 largest market capitalization companies listed on the Shanghai and Shenzhen stock exchanges. These companies have an average market capitalization ranging from tens of billions to hundreds of billions of yuan. The Shanghai-Shenzhen 300 is commonly used as a representative index for large-cap stocks.

**CSI 500**

This index includes the stocks of the 500 companies with the next largest market capitalizations after the Shanghai-Shenzhen 300, representing the mid-cap segment of the market.Including the stocks of the largest companies ranked from 301st to 800th. The average market capitalization of the companies included in the CSI 500 is between 10 billion and 20 billion yuan.

It is generally considered to represent the mid-cap stocks.

▼ CSI 1000

Includes the stocks of the largest companies ranked from 801st to 1800th. The average market capitalization of the companies included in the CSI 1000 is even smaller, with an average of several billion yuan.

It represents the small-cap stocks.

There are still two to three thousand smaller small-cap stocks, which currently lack a corresponding index.

• From 2012 to 2015, the performance of small and mid-cap stocks was better than that of large-cap stocks. At that time, the returns of large-cap stocks were quite bleak, and they were also referred to as "big stinky ones".• From 2016 to 2020, large-cap stocks outperformed mid and small-cap stocks. There were voices in the market saying "the strong get stronger, and the future returns of mid and small-cap stocks won't rise."

• In 2021, mid and small-cap stocks performed better. In 2022, the performance of large, mid, and small-cap stocks was similar.

Long-term returns of different styles are similar

So, are there differences in the long-term returns of different styles?

In the long run, the returns of large-cap and small-cap stocks, that is, the indices of CSI 300, CSI 500, and CSI 1000, are quite similar.

The long-term returns of growth stocks and value stocks are also close, with differences only in the short term.Let's take a look at two more typical indices - the 300 Value Index and the 300 Growth Index.

As the name suggests,

- The 300 Value Index is composed of value-style stocks selected from the CSI 300, reflecting the performance of large-cap value-style stocks in the market.

- The 300 Growth Index is composed of growth-style stocks selected from the CSI 300, reflecting the performance of large-cap growth-style stocks in the market.

Both of these indices started at the same time, both beginning at 1000 points at the end of 2004.

If we also take into account the dividend income corresponding to these two indices, they become the 300 Value Total Return Index and the 300 Growth Total Return Index.How about the long-term returns of these two total return indices?

As of the close on May 1, 2022, the points of these two indices have converged, essentially yielding the same return rate.

It can be observed that every few years, there will be a phase of outperformance by value style or growth style.

For instance, after the bull market in 2015, value style outperformed growth style for three consecutive years from 2016 to 2018.

From 2019 to 2020, the growth style began to make a comeback from the bottom, and by 2021, it had surpassed the value style.From the circled section of the chart, it can be seen that the 300 Growth Total Return Index has a significantly higher point value than the 300 Value Total Return Index.

However, when looking at a longer time frame, the two indices often interweave, indicating that their long-term returns are roughly similar.

Nevertheless, it is clear to see the distinct characteristic of the rotation between growth and value styles in A-shares.

Some friends might ask: Can we invest in the style that is expected to perform better next?

In fact, there is no way to predict which style will perform better in the future.

Based on past experience, the style that is currently underperforming has a relatively higher probability of performing well in the next few years.When investing, we can diversify our portfolio across different investment styles, so that we can benefit regardless of which style performs well.

Rebalancing: Gaining Additional Returns

Diversification can reduce the risk of volatility, but if we only diversify, over time, with the rise and fall of the market, the proportion of different assets will naturally become uneven, losing the effect of diversification.

For example, initially, 50% of the funds are invested in asset A, and 50% in asset B. A and B do not rise and fall in sync. After some time, if A rises significantly more, its proportion will exceed 50%.

Therefore, it is necessary to rebalance according to a certain method.

The benefits of the rebalancing strategy have been studied before, and it was researched by a very famous master, the founder of information theory, Claude Shannon.Shannon is one of the most prominent scientists in modern history, who single-handedly developed information theory, which in turn propelled the emergence of a series of information technologies such as modern communication, computers, and the internet.

He had a keen interest in investing, and it is said that his investment returns were comparable to those of Warren Buffett, although there are no public products to verify this claim. However, he did write some papers on investment directions.

Between 1966 and 1971, Shannon gave several public lectures on investing at the Massachusetts Institute of Technology, with the theme of making money from stock fluctuations.

At that time, Shannon provided an example:

Suppose there is a stock that, in the long term, neither rises nor falls, with a return of 0, but this stock will experience fluctuations in between.

At this point, there is an investor who allocates 50% of their funds to this stock and keeps 50% of their funds in cash.Afterward, 50% is restored each year: a 50:50 ratio.

This is a typical "50:50 dynamic balancing strategy."

Let's assume:

In the first year, 500 yuan is invested in stocks, and 500 yuan is kept in cash.

This stock is halved in value in the first year, so the stock portion becomes 250 yuan, while the cash remains unchanged at 500 yuan.

At this point, to rebalance, we need to take out 125 yuan from the cash. Afterwards, we hold 375 yuan in cash and 375 yuan in stocks.

In the second year, the stock doubles in value.A stock that was worth 375 yuan becomes 750 yuan. Adding 375 yuan in cash, the total assets amount to 1125 yuan.

At this point, rebalancing would result in holding 562.5 yuan in stocks and 562.5 yuan in cash.

Through the example above, we can see:

Even if the stock price is halved and then doubled, meaning there is no net change in the stock price, and of course, the cash remains unchanged as well.

However, through rebalancing, the investor's assets have magically increased by 12.5%.

This is the power of the rebalancing strategy.

Four common rebalancing strategiesSo, what are some common rebalancing strategies?

There are mainly the following four types:

▼ Regular Rebalancing

For example, a 50:50 portfolio, which is rebalanced on a regular basis once a year. It is simple, convenient, and easy to operate.

▼ Rebalancing After Deviation Reaches a Certain Level

For instance, when the allocation of assets deviates from the target by a certain percentage, rebalancing is triggered to bring the portfolio back to the desired allocation.For example, initially at a 50:50 ratio, and then if the ratio reaches 60:40 or 40:60, a rebalancing is triggered.

It is not based on time, but on the degree of deviation.

▼Rebalancing based on valuation

The principle is similar to deviation-based rebalancing, but instead of referring to price, it looks at the valuation.

Because sometimes when the price goes up, the valuation does not necessarily increase.

For example:

An undervalued investment style, allocate a higher proportion;

An overvalued style, allocate a lower proportion.▼ Rebalance According to Volatility Risk

For instance, allocate proportions based on the volatility of each asset class, ensuring that each asset class contributes equally to the overall volatility risk in the portfolio.

Also known as the "risk parity strategy." This type of rebalancing is more complex.

When constructing an active fund portfolio, it is common to diversify by allocating different styles of active funds, with valuation rebalancing strategies being used more frequently.

For example, if a particular style is relatively undervalued in the portfolio, its allocation proportion can be correspondingly increased.

The Power of Diversification + RebalancingWhen it comes to investing, having the concept of diversified allocation plus rebalancing is very important.

Many friends find the investment experience to be poor and difficult to persist in, often because they put all their money heavily into one or two types of investments.

Let's look at a story.

Aunt Wang has two daughters, the elder one sells umbrellas, and the younger one sells cloth. Aunt Wang worries about:

- On rainy days, she worries about the younger daughter's business not being good;

- On sunny days, she worries about the elder daughter's business not being good.Assuming the two daughters have the same ability to make money in their businesses.

Over time, they will experience countless sunny and rainy days, which is to say, they will go through countless small cycles of ups and downs. In the end, both daughters will be profitable.

In fact, Aunt Wang only needs to think from a different perspective, and there is no need to worry about a particular sunny or rainy day.

As shown in the figure below, sunny days are when the second daughter's business is doing well and she is happy, while rainy days are when the eldest daughter's business is doing well and she is happy.

And, if the two daughters are more astute:

- On rainy days, the second daughter helps the eldest daughter by selling more umbrellas.On sunny days, the eldest daughter comes to help the second daughter, selling more cloth.

This will have a better effect.

This is the power of diversified allocation and rebalancing.

Let's do a backtest, selecting veterans with a value style and growth style who have been in the industry for more than 10 years.

From the beginning of 2016 to March 2022, the returns and drawdowns of veterans with different styles are shown in the figure below.That is to say,

- Allocating solely to the growth style veteran, the return rate is approximately 70%, with a maximum drawdown of about 37%.

- Allocating solely to the value style veteran, the return rate is approximately 85%, with a maximum drawdown of about 24%.

- Assuming an equal 50% allocation to both veterans, with an annual rebalance. Such a portfolio would yield a total return of about 97%, with a maximum drawdown of about 28%.

It can be observed that the third scenario offers a higher return than the first two, while the maximum drawdown is in between, which is to say: 1 + 1 > 2.

Two points should be noted here:

- First, the objects of diversified allocation and rebalancing need to be out of sync in their ups and downs, such as different styles, one selling umbrellas and the other selling cloth;Here is the translation of the provided text into English:

- Second, both subjects need to have good long-term returns, just as whether selling umbrellas or selling cloth, both should be profitable in the long run.

Summary

By employing a strategy of diversified allocation and rebalancing, one can construct a fund portfolio that reduces volatility risk while also capturing some investment opportunities, thereby enhancing the returns.