Signal Performance as of
Stocks started the week by moving slightly higher Monday as investors
were waiting for the Federal Reserve's decision on interest rates. As
had been widely anticipated, the Fed announced Tuesday that it was
cutting the funds rate by 25 basis points to 4.25%. The market sold off
on the news as some investors were disappointed that the Fed did not
move more aggressively by cutting rates by half a percent. In the
accompanying statement, the Fed noted that economic growth is slowing
but did not strongly signal that additional cuts are on the way. The
resulting uncertainty only added to the selling pressure, causing all
major indexes to close with significant losses on Tuesday. Before the
open Wednesday, the Fed and several other central banks announced a
coordinated initiative to add liquidity to the financial markets in
order to help cash-strapped banks. Stocks jumped on the news but
relinquished most of their gains after Bank of America and Wachovia
announced that write-downs related to their credit and mortgage problems
will be greater than expected. Markets were almost unchanged Thursday
but closed the week by moving lower Friday as inflation fears resurfaced
following the release of the Consumer Price Index (CPI) for November:
consumer prices rose 0.8% last month, topping the 0.6% rise economists
For the week, the Nasdaq 100,
S&P 500 and
Russell 2000 experienced
respective losses of 2.72%, 2.44% and 4.02%. The Nasdaq 100 now rests
just below its 50-day exponential moving average (EMA) while the S&P 500
and Russell 2000 are situated below both their 50-day and 200-day EMAs.
For its part, our World Index Ranking portfolio
lost 2.63% this week.
The portfolio consists of the 5 top-ranked world indexes as
of December 7, which marked the beginning of the current 4-week
Our current Buy
signal remains in effect.
art of rebalancing
At first glance, rebalancing to implement the World
Index Ranking strategies appears to be the simplest
thing in the world but then, if you start to poke, a lot of
questions arise as to the exact best way to do it. Since the
failure to see the benefits of periodic rebalancing and uncertainty
about the proper procedures to follow can lead to confusion
and inaction, we are dedicating this issue to the ins and outs
In personal finance the term rebalancing is frequently used
in conjunction with asset allocation strategies in which you
attempt to keep your money distributed between asset types such
as bonds, equities and Treasuries in fixed proportion. The common
definition is the process of buying and selling portions of
your portfolio in order to set the weight of each asset class
back to its original allocation. In our case, in addition to
managing the 20% position allocations (in the case of our favored
5 position portfolio), we also use rebalancing to periodically
upgrade our portfolio to the latest ranking and the strongest
Rebalancing imparts to the World Index Ranking
system its trend following dynamics. The ranking, driven by
our relative strength model, reflects the evolving momentum
of the various market indexes and the corresponding ETFs in
which we invest. Rebalancing also serves as a way to take the
gains from the winners off the table (sell high) and use these
gains to purchase under-weighted positions (buy low).
For a complete tour of rebalancing and all its intricacies we
will examine the following variables, in no particular order:
How many positions in our portfolio?
For our purposes, 5 positions offer a good tradeoff between
sufficient diversification and diminishing returns because indexes
ranked 6th through 10th are not as strong
as the Top 5. We begin with 5 equal sized, un-leveraged positions
in the Top 5 world indexes.
When and how frequently is the World Index Ranking updated?
The World Index Ranking Model is run at the
end of each trading week on Fridays, and the updated list is
posted on the Web site by 9:00 pm ET.
How frequently do we rebalance our portfolio?
Our research and testing has shown that the optimum rebalancing
period is 4 weeks: it provides excellent returns while minimizing
trading commissions. Rebalancing more frequently, say every
week, increases churn and trading costs but does not improve
performance. We update the rankings every week so that subscribers
can start at any time on their own 4-week rebalancing schedule.
How do we rebalance to the latest ranking?
By selling the indexes which have slipped out of the Top 5 and
buying the new ones. Since our system has a low turnover, there
are frequently only one or two positions to rebalance. For the
results we publish, we always use equal position sizes at the
beginning of every period, but this is not necessary for your
trading. It is OK for the various positions to grow/shrink at
different rates and only when one gets too far out of line do
you need to rebalance position sizes.
When and how do we rebalance position sizes?
A good rule of thumb is to rebalance when, instead of the nominal
20%, one position shrinks to represent 15% or less, or grows
to account for 25% or more of the entire portfolio. Simply sell
the excess shares in the oversized position(s) and buy into
the under-weighted one(s).
How is rebalancing different in Long Only and Long and
The rebalancing process is not changed as much as it is interrupted
by Cash and Sell
signals, except for the Buy and Rebalance strategy
which ignores the signals altogether. The 5 positions get sold
and either stay in cash or are applied to the short position.
When a Buy signal
resumes, the 5 positions get reinstated with the then current
Top 5 indexes.
In short, rebalancing is critical for performance by staying
positioned in the strongest markets, and for risk management
by maintaining effective diversification. Once we get past all
the questions and parameters, all we need to remember is to
rebalance to the Top 5 every 4 weeks. Maybe it is in keeping
it simple that the art of rebalancing can be found.
Why is INP on fire?
Because anyone actively investing with the World Index
Ranking has benefited handsomely from INP (the iPath
MSCI India Index ETN), it is up over 30% in just the last couple
of months, this FAQ will go into the nice surprise
category. Alas, the episode simply reminds us that investing
in India remains an adventure fraught with many dangers as long
as the changing restrictions by the Indian government on foreign
investments prevent a normal ETF to exist and operate for that
We have written about the trials and tribulations of Indian
you missed recent price action, a look at the short-term performance
of various India closed-end funds and the INP exchange traded
note (ETN) in Chart 1 below reveals how INP
surged ahead of the others lately.
Chart 1: 2 month performance of India funds
Here is a timeline of events leading up to the current imbalance.
On October 25, 2007, the Securities and Exchange Board of
India (the "SEBI") implemented further regulations (restrictions)
with respect to derivative instruments linked to Indian equity
securities. Unbeknown to most of us, since Barclays did not
deem it necessary to issue a press release, on October 26,
2007, Barclays said that in light of the SEBI's announcement,
Barclays would suspend issuance, sale and lending of INP except
from inventory (additional legalese deleted here). They also
amended their prospectus with language such as "... the market
value of the Securities (INP) may be influenced by, among
other things, the level of supply and demand for them." Thank
you for letting us know now. In short, INP went from being
open-ended like an ETF to being closed-ended, and the direct
short-term consequence is that price premium has made its
apparition. As shown on Chart 2 below, while
the closed-end funds IFN and IIF have been trading at a discount
of about 10%, INP has begun trading at a premium. In fact,
as of December 12, 2007 that premium was up to 20.2%.
Chart 2: Discount/Premium of India funds
Just as the premium of closed-end funds evaporated, some day
the premium of the INP ETN will evaporate. From here on out,
the odds would appear to favor the 10% discount of an IFN
over the 20% premium of an INP.
Warm wishes and until next week.
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