{This post is an edited excerpt of the November 2020 letter to our Subscribers}.
Hope it adds Value to you.
November turned out to be a good month for the Portfolio. For the Multi Cap Portfolio, this has been the first complete month. The Multicap Portfolio registered a gain of 7.87% for the month. This was a month for the laggards with the best performance being from Metals and Financials leading. The rally for now is pretty broad and yet the markets are not at a juncture where we have seen tops emerging in the past. Will this time be different, only time can tell.
Anchoring bias impacts us in many ways, some known and some unknown. One question I keep getting asked is why the Portfolio Rebalancing is Monthly and not Weekly. I shal try to address this question via this long drawn post.
But why is such a question asked in the first place. While India doesn’t have any Momentum ETF’s, the US has many ETF’s that are based on the Momentum Philosophy.
One common attribute across the ETF’s – the rebalancing happens every Quarter. A few rebalance just twice a year. Closer home, the new Nifty 200 Momentum 30 Index has a rebalancing schedule of half yearly while the older Nifty Alpha 50 and Nifty 100 Alpha 30 rebalance quarterly.
In Annie Duke’s latest book – How to Decide, she provides a Six step path to a great decision process. Whether or not this is a great decision will be proven only in time , but in this post, I thought of using the framework to try and explain why Portfolio Yoga Momentum Portfolios are rebalanced Monthly against the conventional way of using Weekly rebalance schedule and the Trade offs we face in this regard.
Why do we rebalance the Portfolio
The answer to that question lies in the fact that stocks that are in Momentum suffer what we call as Momentum Decay. What this means is that given no stock can keep going up higher for ever, the law of diminishing returns starts somewhere and our objective is to ensure that we are out of the position before such a possibility happens to our portfolio stock.
This is true for a Value / Growth Investor too. If you are a value investor or a growth investor, you watch out for decay in terms of company fundamentals or the growth. You get basically 4 data points per year to analyze whether the company’s progress is as per what you estimated and if the stock is still worth holding on to.
Indices rebalance removing stocks whose market cap has fallen and replacing them with stocks whose market cap has risen subject to the stock also fulfilling certain other criteria.
The big question though is how frequently should one rebalance. Indices such as Nifty 50 do it twice a year, Momentum Exchange Traded Funds in the United States rebalance for most part once a quarter with some doing twice a year as well.
In India, most advisors offering Momentum factor strategies rebalance on a weekly basis. We on the other hand have stuck to our choice of doing the same on a Monthly basis.
Why Monthly vs Weekly or Quarterly
The best rebalance period is Daily. This ensures that stocks can enter and exit the portfolio at the earliest opportunity. Unfortunately, this also means that there is not only a very high amount of churn but also stocks have very little opportunity to prove themselves. Unlike other strategies, in Momentum we are looking at Cross Sectional strength – what this means is that not only has the stock we wish to add or wish to continue to be part of the portfolio need to be good but it should be good relative to all the other stocks in contention. This results in a constant move in ranks – the sharper the move, smaller the lookback.
Weekly is NOT the time frame that is discussed in a lot of literature. If you check out any of the Academic Papers, you shall find that most of the testing happens with a monthly time frame. Yet the community in itself has embraced weekly. What explains the conundrum?
One reason is that many hold the strategy as a satellite strategy and not the core portfolio. “What’s in a name? that which we call a rose. By any other name would smell as sweet.” ― William Shakespeare wrote in Romeo and Julie and yet somehow it seems the name accounts for a large part of how we look at a strategy in itself.
One of the reasons Momentum is seen as a Satellite Portfolio and not a Core Portfolio is because of the number of transactions. Investopedia says that Core-satellite investing is a method of portfolio construction designed to minimize costs, tax liability, and volatility while providing an opportunity to outperform the broad stock market as a whole.
Since launch I have had numerous discussions with both subscribers and prospective investors and the one common thread for many is the way they treat Momentum Investing vs Value or Growth Investing. The comfort factor that comes with other strategies is missing in a pure price action strategy such as Momentum.
Add to it, transactions are a distraction for most investors. They would rather prefer to just buy and forget than having to keep changing the portfolio regularly. By investing in a Mutual Fund or a Portfolio Management Service, we try essentially to outsource this painful activity.
Weekly rebalancing when done with the same exit criteria as monthly has 80% more transactions. While you can reduce the transactions by having a larger rank exclusion (say instead of saying I will exit a stock once it goes below rank 50, changing it to 100 will provide for lower transactions), the constant need to check is in my opinion a hassle especially as the size of the portfolio gets larger.
The Upside and the Downside
First, let’s talk about the Upside and the Downside of having a monthly rebalancing strategy.
The biggest upside for obviously is the lower number of transactions. While some costs can be measured, some others cannot. The biggest cost when it comes to churn for instance is not transaction costs – they aren’t that big but the slippage that goes unseen.
While slippage differs from stock to stock, unless you are investing in large cap stocks only, the pressure of multiple people trying to buy a stock at the same time can push the spreads dramatically upwards.
A couple of decades ago. I was a trader in a regional stock exchange. Liquidity other than for a handful of stocks was brutally low. This meant that we never used a market order to place orders for the Impact cost would kill whatever small margin we hoped to produce out of the trade.
Liquidity begets Liquidity and hence we find that BSE is finding it tough if not impossible to match let alone beat NSE in terms of market share. But even on the NSE, liquidity is pretty limited outside of the top 100 to 200 stocks.
The problem is accentuated by the fact that today Momentum Investing is seemingly coming to be a mainstay of small investors who aren’t wary of placing market orders in order to get a confirmed fill. Add to the mix the fact that 80% of the stocks across most momentum advisories will be similar, you have a potent mix that can make buying and selling expensive as a whole.
While we use filters to eliminate low liquid stocks, the spread is not known for most stocks and even in fairly liquid stocks this can be killing. Monthly in a way limits this by ensuring that the number of trades are fairly limited. To understand how Impact Cost is calculated, do check this by NSE NSE – National Stock Exchange of India Ltd. (nseindia.com)
A bigger factor is also our belief that stocks don’t go up vertically and those that do are not worth risking big money upon. They tend to move up, flatten while oscillating in a range before they commerce the next move. By trying to be with only the top stocks all the time, we will end up getting out of trends before the trend has truly exhausted.
While the advisory is just one month old and hence doesn’t have data to back my statement based on my own data, the average holding period has been to the tune of 4.5 months with quite a few being held for more than a year.
Our attempt here is not to maximize returns. That would require me to have a smaller focussed portfolio and a high churn rate. While that would be an attractive marketing strategy, I for one would not be comfortable investing a substantial amount of capital in such a strategy and it would be hypocritical to ask clients to do what I ain’t doing myself.
The portfolio we offer on the other hand provides me comfort and hence as of today comprises nearly 65% of my networth.
Disadvantages of Monthly when compared to Weekly rotation
Let’s look at the downside of Monthly vs Weekly. The biggest downside was seen in March of this year when markets meted down inside of a month. This was the biggest monthly drop for the Nifty 50 ever outlasting even the fall of October 2008. A weekly strategy would have saved me 10% (I closed the month with a loss of 23.70%) and while 10% seems not much, the fact that to recoup a 10% loss requires a bounce of 11% and that is a missed opportunity (remember, the gains would have come anyhow).
On the face of it, it seems that Weekly makes more sense than monthly. But the downside of constant tinkering comes at the cost of allocation. Higher the number of trades, lower is one’s ability to deploy a significant sum of money.
To deploy a significant sum of money, a strategy or an asset class should fulfill two conditions
- Its something you feel will not let you down and will not make you lose sleep. A reason Real Estate is a preferred way to invest for majority is because of its ability to remove the friction and noise that pervades other asset classes like Equities.
- The ability to not have to transact often and one reason why there is so such of stickiness with mutual funds even when results aren’t in favor. Unless the investment is a substantial part of one’s net worth, most are happy to let it stay than keep shifting.
The advantage of Direct Investing comes in two parts – one the ability to have a better control on the portfolio composition and secondly the ability to shift with the winds of change. On the downside though, it’s easier than say with Mutual Funds to interrupt the process of long term growth.
More the transactions, more the confusion as to whether to follow or ignore. After all, there is always a chance that the stock going up will go higher while the stock that entered in its place goes lower (and while the portfolio is just 1.5 months old, we have seen that happening with Globus Spirits which went out in October rebalance to be replaced with Astec).
It has taken me way too long to figure out that the best way to grow our wealth in equities is to concentrate – not in terms of stock but in terms of philosophy. Every strategy has its good days and bad days but if one were to stick with it through thick and thin, the outcome would be far better than shifting with the winds of change.
Comparative Statistics for Monthly vs Weekly using the same Entry and Exit Criteria
Post March, we have implemented a trigger to allow us to move to weekly in case of big market volatility. Again, no two market crashes will be the same. The March fall and subsequent recovery has never been seen in history – the fastest ever comparable crash and bounceback was seen in the US in 1987 and even that recovery took nearly 2 years. But this addition provides a comfort that if things go to shit one again (and the odds of such a thing happening in say the near future is very low), the portfolio strategy is well prepared to handle the same.