Portfolio Rebalancing and the Re-weighting of International Small Cap

During June we conducted our annual rebalancing process--adjusting each client’s portfolio back to the target asset allocation of the client’s investment plan. While disciplined adherence to asset allocation is a big driver of investment performance, there is a growing body of research showing that, in the case of rebalancing, less is more. This is due, in part, to the fact that, absent cash flows into or required withdraws from a portfolio, rebalancing trades can invoke otherwise avoidable taxes and transaction costs, reducing the potential benefit. Still, letting winning asset classes ride too long and asset classes that are relative losers go under-funded too long can be a recipe for portfolio pain as asset class dominance shifts. That it will shift is certain; when, of course, no one can be sure. Consequently we focus on curing developing imbalances annually…but not more frequently than that, and we continue to refine our trading rules to increase the likelihood of beneficial outcomes for rebalancing. Ultimately, we weigh the benefits of any rebalancing trades against any incremental tax and transactions costs for each client portfolio.

This year our rebalancing process coincided with a general change in the weighting of clients’ developed overseas allocation between large capitalization stocks and small capitalization stocks. We previewed this change in our 1st Quarterly Commentary in April. In the past, we had divided most clients’ overseas allocations 80% to large cap and 20% to small cap stocks. Our new division, 60% large cap and 40% small cap stock, is both more consistent with the large cap/ small cap relationship in domestic equities and reflects increasing evidence that small cap stocks overseas do enjoy a performance advantage.

We have long believed that the premium available domestically from small cap stocks versus large caps should also be available overseas. But the overseas small cap stock asset class is still relatively new and the risk/reward ratios have not been well documented until recently. During our recent review of capital market expectations, we found more research supporting the existence of a small cap premium overseas, with risk levels similar to those in the US. We are now even more confident than ever in the value of small cap investing overseas. In last quarter’s Commentary, we presented our updated capital market expectations and showed the domestic small cap premium at 175 basis points above large (i.e. we expect small cap stocks to return 1.75% above the return from large cap stocks). In affirming the expectation of earning the small cap premium overseas, we estimate it at the same rate or 1.75% above the return on large cap stocks overseas.
 

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