Swedroe: Valuation Metrics In Perspective

November 11, 2015

Again, the static portfolio produced the fewest transactions at 37, although the gap was now smaller because of the increasing hurdle represented by two standard deviations (the three valuation-based strategies required 45 to 56 transactions, with the CAPE 10 producing the fewest). And once again, very similar results were found when the 30 percentage point shift and two-standard-deviation rules were applied.

Estrada noted that the Sharpe ratios for all the portfolios were virtually identical, at about 0.22. Thus, whether more or less aggressive shifting strategies were used, or higher or lower hurdles (one or two standard deviations) were employed, results were the same. There was no improvement in either returns or risk-adjusted returns. And this was even before considering transactions costs or taxes.

Frequency Of Rebalancing

While the historical evidence suggests that infrequent rebalancing (perhaps once a year) is sufficient to efficiently control risks, some investors do rebalance on a more frequent basis. Thus, Estrada also examined whether the performance of the strategies would benefit from monthly rebalancing.

The tactical strategy based on the P/E metric did achieve a slightly higher return and slightly lower volatility, and therefore a slightly higher risk-adjusted return, than the static strategy. However, the other two tactical strategies (the ones based on D/P and the CAPE 10) either did no better than the static strategy or did worse (with both lower returns and higher volatility).

However, the P/E-based strategy also triggers many more rebalancing events than the 60/40 strategy, from 3.5 times to as much as almost 9 times greater depending on the choice of volatility metrics (one or two standard deviations) and percent allocation shifts (either 20 percent or 30 percent). Thus, the 60/40 portfolio has much lower transaction and tax costs.

Estrada also noted that while the P/E-based strategy performs slightly better under monthly rebalancing than under annual rebalancing, the opposite is the case for the other three strategies considered, which raises the question of whether or not data mining has occurred. Torture the data with enough strategies and eventually it will relinquish a confession in the form of a strategy that worked in sample.

Estrada concluded: “The evidence does not support the superiority of valuation-based strategies; if anything, it points moderately in the opposite direction. In fact, the slight advantage of the 60-40 portfolio does not even take into account that this strategy does not require investors to track the historical performance of multiples and to evaluate whether they signal overvaluation, undervaluation, or fair valuation. In other words, simplicity would add another vote for the 60-40 portfolio.”

The bottom line is that the bulk of the evidence on valuation-based strategies seems to suggest that it’s difficult to find some trading rule that would have significantly outperformed a balanced portfolio in the past, even with the benefit of hindsight. What’s more, that’s without taking into account the real-world trading costs that all investors incur, or the taxes that taxable investors must face.

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