A Trade, by any Other Name…..

Let us be crystal clear on one thing; equity rebalancing, automatic or otherwise, is TRADING.

Can it be that the industry which made their fortunes on high fee mutual funds, now fully migrating to exchange traded fund promotion, seeks to maintain revenues via a shifting away from management fees, towards incremental transaction expenses? The ETF industry now maintains more than 1/3 of all investment assets, why not promote forced portfolio turnover within ETFs?

Hence, marketing of the next big thing, “automatic portfolio rebalancing”. Such propaganda, typically provided from the portfolio administrators/managers themselves or from traders, represents vested interest and is far from objective. The pushing of portfolio rebalancing is pervasive, to the point that most now only pay lip-service to the notion of buy-hold, even among those who consider themselves to be long term investors.

To illuminate the wealth limiting impact of a supposedly benign, capital preservation policy marketed as “automatic equity rebalancing”, look no further than the FANG Plus index.

FANG Plus Index presently holds 10 equities: Meta, Apple, Amazon, Netflix, Microsoft, Google, CrowdStrike, Nvidia, Service Now, Broadcom. Crowdstrike and ServiceNow were added just this month, replacing Snowflake, which was purchased in December 2022 and Tesla, which was purchased in 2017. Over the years, Alibaba and Baidu were added and subsequently sold. Advanced Micro Devices was purchased in 2022 and sold out just 9 months later. Twitter was purchased in 2017 and subsequently taken over, but roughly 1/2 of the original position was sold beforehand. 6 equities, of a 10 equity package, no longer exist at all in the index, having been sold away.

Since inception, the Index has returned 27.5%+ annualized. That return has been achieved with quarterly rebalancing so that all positions are equally weighted. $1 million invested in the index in 2014 and reconstituted in 2017, was, at the end of September 2024, worth in excess of $11.40 million. A fantastic return.

As good as that FANG + Index return has proved, from afar; the active, regimented, automatic rebalancing of this concentrated portfolio has proved to be highly detrimental to the wealth accumulation journey of FANG Plus participants. By eliminating portfolio rebalancing, had the equity positions been constituted with an initial equal weighting and then just left bloody well alone, investors would be sitting on an equity value of $15.02 million, not $11.40 million. Trading away, of the top performing equities, in what may be considered the top performing concentrated index for investors globally, has penalized participants who had $1 million for investment, to the tune of an opportunity cost in the amount of $3.62 million. Persistent selling of the winners, reallocation into the relative laggards in an account; this represents more than a statistical conundrum, it is wealth prevention.

Capital was repeatedly, consistently, quarterly, sold away from Nvidia, and to a lesser extent Tesla. These funds were reinvested in Meta, Google, Apple, Amazon, Microsoft and several others, 8 separate equities in total. As familiar as those names are to the investing public, they were absolutely left in the dust by Nvidia and Tesla. In the case of the Fang Plus index, more than 30% of the potential capital appreciation, despite prescient stock selection, was lost due to trading. To fully rebalance quarterly, annual portfolio turn, at times, approached 100%. Presently, less than 20% of the original share count in NVIDIA remains. As for the 80% that was sold, had it been held in a taxable account, it represented short term capital gains on a tax filing.

“I am sure glad that my ETF administrator sold off significant chunks of my top performing investments, more than 80% of my biggest winner, for no other reason than to provide cash to average-down into my worst performing investments.”

“I am even happier that my administrator persistently sells off the laggards after years of averaging down, further compounding loss.”

“I am absolutely ecstatic about the high current taxation that occurs with a portfolio turn annually approaching 100%, leaving me with far less money than I would have had using a simple buy-hold approach”

…said no one, ever.

When investors talk up great regrets, what really hurts the most are not the ones that they completely missed; no, what sticks in their craws are the investments that they didn’t hold enough of, or that they sold out for a short term buck and subsequently turned out to be the makers of staggering fortunes for others.

Yet, we repeatedly fall, hook line and sinker, for program trading operating under a pseudonym?

Maybe institutions are infatuated with automatic portfolio rebalancing because the name represents a misdirection, a sleight of hand, from what it actually is, just another stock trade.

The marketing hook on automatic portfolio rebalancing is heavily tied into the disclaimer that “past performance is not indicative of future performance” (“please don’t expect similar returns on any given investment that were generated in the past but we packaged product sellers have a nifty solution”). And, the more stock trades occur, the greater the spread credits are to be earned, the more money is removed from your account and kept by the house. Ponder that thought, not for a day, but for a very long time.

In any event, portfolio capital allocation changes are noted daily in your account, without so much as a trade. Equities, through their second-by-second increases and declines against other equities, for a wide variety of reasons, immediately shift their weightings in every account. If Microsoft underperforms a bit against Netflix in any quarter, the fact that your percentage holding in MSFT differs at the end of the quarter against Netflix, that represents a form of rebalance and you didn’t lift a finger. This is what markets do, they assess outlooks and change values accordingly. But the actual selling off winners, for no other reason that they are a winner, based upon some fluffy statement that “equities always revert to the mean”, represents a deeply ingrained bias, pushed on us through persistent, possibly insidious, certainly self-serving, marketing by traders.

Yes, had one held Nvidia and Tesla from 2017 through today without a sale, they would have a massively outsized investment and a relatively outsized investment, in relation to the remainder of the FANG account. But, there IS a sum for which I will accept an ongoing measure of discomfort. $3.6 million, the account value foregone through the sales of both equities, is such a sum.

“Past performance is not indicative of future return” may be one of the more profit limiting statements promulgated on the public by the professional investment industry.

Past performance matters greatly, to society, to most businesses and to the economy at large. The United States is the best economy in the world, over time, due to competitive advantages over other economies. Hundreds of years of past performance have brought the USA to this present level of economic dominance. Competitive advantages, driven by prior actions, mean something. Why then, should we pretend, for no other purpose than a compliance driven “CYA”, that past performance is irrelevant for individual businesses within public stock markets? A complete dismissing of historic performance is a mistake, because past performance is far more than just a stock price value; rather, past performance represents an assignment of a qualitative appraisal. It is based, largely, upon profit margins and growth prospects that become part of the enterprise valuation calculation.

In professional sports, bookmakers assign preferential odds to teams entirely based upon perceived qualitative advantages vs competitors. This creates the “favorite” vs the “underdog” spread. Far, far, far, more often than not, the favorite wins, not only in the winning, but doing so at the spread. Oddsmakers assign weightings before a professional league even begins a season of competition, based entirely upon the perceived health of key athletes. In cycling, races are almost always won by a cyclist sitting at or near the top of the global rankings, supported by a talented group of specialists on either the same team, or with collaboration during the race by non team members who assist, in the expectation of a future quid-pro-quo. Tennis players, golfers, track and field athletes, gymnasts, swimmers, divers; all have world rankings commensurate with their PRIOR success in that sport, because the expectation is that prior success represents the culmination of a vigorous training regimen, personal health and physical attributes that enable said athlete to perform, consistently, at a level above peers.

In real estate, the global dictum for selection is summarized at follows: “location, location, location.” Even the worst property in the best location tends to outperform the best property in the worst location, over time. Ocean front in southern California or Miami always outperforms, from a valuation increase perspective, over time, the inland locations in the United States. And, while SoCal ocean front is, to those living in the US Midwest, absurdly overpriced, the returns have justified purchase. Just as one never needed, from an investment perspective, any piece of real estate other than a single large Malibu beachfront acreage, to hold it for decades, despite the pleas from SoCal realtors to break it up and sell off a piece here and there, for the purpose of “diversification of wealth”, why is Wall Street obsessed with equity portfolio rebalancing as a method of diversification?

I consider the concept of automatic portfolio rebalancing to be one of the greater short cons marketed to the investing public at large.

Automatic portfolio rebalancing is at the very heart of Robo-advisor portfolio packages; “let us assemble you a portfolio of exchange traded funds and our bots, driven by algorithms, will regularly shift money from one ETF to another”. Sadly, most of us have fully abdicated our personal responsibility for building personal wealth, being overly reliant upon gurus and packaged products to chart our course, so we bite into this hook and too many are now stuck. ETF investors believe that their returns actually match the individual returns of the stocks in that index, less a modest administration fee. In almost every case, they do not and sometimes returns are not remotely close. In the very specific case of what might be the most popular concentrated tech index out there, the difference between what was actually earned vs what could have been earned represents a highly cautionary tale on the perils of trading disguised as a rebalance. People haven’t caught on to the short con, so the industry has decided to run with it full tilt; the short con is now a long con.

If automatic portfolio rebalancing of concentrated growth equities neither mitigates risk, nor maximizes reward; if the policy is not benign, but punitive, why do it?

The Fang Plus Index isn’t assembled and allocated by any normal mutual fund operator. No, the index is overseen by the mighty Intercontinental Exchange Group (ICE), the owner and manager of the New York Stock exchange, 6 global clearing houses and a host of futures exchanges worldwide. As the gateway, processor and settlor of the bulk of investment, futures and options transactions globally, their database and tracking systems are unrivaled on the planet. Rest assured, if ICE cannot manage to generate incremental profits, or even run a value neutral system of harvesting profits for reinvesting into laggards, nobody can. Rest assured, if the best that ICE could do with an automated selling of winners to average down into losers is a 32%+ reduction in buy-hold profits, then every other investor on the planet will logically produce a worse result.

Not only does ICE have a database and tracking system advantage, they also have an information advantage. Trading of any equity can be halted by ICE at any time pending the dissemination of news, news that they see before the public and that is the critical advantage in trading. ICE can even go so far at to cancel trades that they consider to be detrimental to their interests. The deck is entirely stacked in the favor of ICE. All this taken into account, the Intercontinental Exchange Group has still failed to dollar cost average and trade away from high growth positions for the net benefit of the ETF Index that they, themselves, created.

A DIY solution might be the best and, perhaps, the only practical approach to addressing an industry rollout of automatic portfolio rebalancing.

Any individual could have assembled the FANG Plus portfolio in 2014 with 5 purchase commissions, then invested in the 2017 additions, set up a complimentary dividend where applicable and then headed back to the day job. Even after the misadventures from Alibaba, Baidu and Snowflake, they would now have more than $15 million of capital on a $1 million outlay, at a total commission of perhaps $130 US (not annually, total). There would have been very modest current taxation relative to the value of the portfolio, just a bit due annually on the dividends paid into taxable accounts and virtually no current capital gains assessments, as you didn’t turn over 100%+ of the account annually in rebalance. The Alibaba, Baidu and Snowflake positions were sold at a loss or a break-even for a limited tax event, likely offsetting the Twitter takeover premium. The DIY investor would still hold Nvidia in full, Tesla in full and Advanced Micro Devices, three of the hottest equity performers this decade.

Yes, it would have proven to be highly uncomfortable, for a time, perhaps even through today, to witness the outsized value of Nvidia and Tesla on your statement, as compared to the remainder of the account. Such discomfort may be alleviated with a tasty beverage, now and again, from the grapes harvested at your Tuscan estate vineyard; a winery paid for with that $3.6 million of incremental value you earned, as a result of steering your equity portfolio well clear of the clutches of automatic portfolio rebalancing traders.

Furthermore, many investors sought out the reconstituted FANG Plus Index in 2017 due to the inclusion of Tesla. Inexplicably, Tesla, the second largest winner ever held within the index, was sold entirely out from the account. This means that an investor, seeking participation in Tesla, would be forced to repurchase shares of Tesla in some other fashion, at the current price. Owners of the index, since 2017, would have been responsible for their pro rata tax associated with the prior rebalancing (profit-taking) over the previous 7 years as not only was NVDA sold down sharply, so too was Tesla.

I have, over decades, faced some level of pushback by certain non-client traders who refuse to acknowledge any legitimacy to the practice of “let winners run”.

Even a high quality buy-hold portfolio that has demonstrated index beating returns, apparently, isn’t good enough for a trader. Their headspace is: “let us OVERLAY a trading model onto fundamental stock selection; that has GOT to improve returns even further.” To which I respond: “don’t waste your energy. If ICE cannot do it, what makes you think that you can?”

The marketing proponents of automatic portfolio rebalancing then redirect to their fallback rebuttal: “portfolio rebalancing isn’t really a profit neutral solution, it is a risk management tool, designed to lower concentration risk and reduce downside.” To which I respond: “is ANY investor seeking to hold a concentrated technology portfolio of just 10 large cap growth stocks worried in the slightest about concentration, let alone be fretting with risk reduction?” No, that’s the last thing on their minds, they choose technology portfolios in order to maximize return. Concentration reward is what they choose to accept and that comes with concentration risk.

Finally, if automatic portfolio rebalancing is, quietly, acknowledged by the industry to be profit reducing, then why not indicate it as such so that investors can opt out?

But, that would wreck the order flow and damage, potentially irrevocably, the transaction model now accelerating throughout the entire index investment management business.

What’s wrong with concentrated accounts anyway? It is how the uber-rich have accumulated their incredible wealth.

Investors hold up Warren Buffett of Berkshire Hathaway as a paragon of investment acumen. They have had no issue with Berkshire Hathaway holding a highly concentrated account in the past; one where, until very recently, Apple Inc. accounted for a whopping 39% of the public investment portfolio. So, apparently, concentration of holdings isn’t an issue for some, such as Elon Musk, Bill Gates, Jeff Bezos, Mark Zuckerberg, Peter Thiel, Bernard Arnault and Jensen Huang. The bulk of their net worth is tied up in one or two equities. The ultrawealthy maintain concentrated portfolios, let winners run over decades, but the public is expected and counselled to invest differently? Just how does any individual ascend global wealth rankings by hamstringing themselves with policies that market one to invest differently from those of ultra high net worth?

The value destruction of the FANG PLUS portfolio lays bare, as false, one truism of the markets; that profit harvesting of winners, to be dollar cost averaged into laggards, represents a sensible stratagem.

More than 50% of professional active investors underperform indexes (more or less, in any given year). Individual investors, on the whole, woefully underperform professional investors. As it turns out, the top concentrated index under the sun has managed to pick winners; but via trading rebranded as equity rebalancing, has simultaneously served to destroy roughly 1/3 of the potential wealth that would have accrued from a simple buy-hold; what does that suggest is the likely outcome for ANYONE who believes, wholeheartedly, in the practice of portfolio rebalancing (trading), specific to a non-randomized selection of equities? Will you be the one, maybe the only one on the planet, who possesses such acumen? I certainly lack such skill, nor, evidently, do the creators and administrators of the FANG Plus Index themselves possess the requisite skillset.

As indexes become increasingly active; as passive indexes speed up the pace of inclusions/deletions, this increased turnover comes at a cost, a transaction cost.

The only way to control such costs is to refuse to play the transaction game. We serve our wealth creation goals best by focusing upon equity selection, the owning of winners; let the markets do what they do.

Keep this minority viewpoint in mind, the next time an investment manager, investment bank, or you, yourself, promote the supposed merits of automatic portfolio rebalancing. Remove the impetus to trade away your winners. Occupy your time with holding a stellar group of equities and get on with your life, your day-job, with walking your dog.

My account capital allocation shifts daily, due to market pricing, as does your account. To further put my thumb on the scale is nothing more than hubris and personal vanity. None of us possess the real-time data that is the lifeblood of the Intercontinental Exchange Group; if ICE is putting their thumb on the scale, then it would seem abundantly clear that the purpose of automatic rebalancing, the selling away of winners, is to reduce individual profits. Because that is what it does.

https://www.ice.com/equity-index/fangplus