A Rules-Based Approach to Managing a Portfolio

A prelude to this week’s commentary: BlackRock made financial news headlines by announcing a change in how some of its active mutual funds will be managed. Rather than rely on human stock picking, the company is shifting to a heavy reliance on quantitative strategies. Commentary about the change was quick to use the word “robots” to describe the funds’ new managers.

BlackRock’s decision comes as the active versus passive debate continues. Just five days after BlackRock’s announcement, The Wall Street Journal ran an article headlined, “Active Managers Stage a Comeback.” The article, citing data from Morningstar, said that 45% of all active U.S.-based managers (including stock and bond fund managers) beat their respective index alternatives.

Those of you looking at this back-and-forth between the so-called quants and traditional active strategies should realize that you don’t need to have a proverbial dog in this fight. You can choose quantitative strategies or you can choose to use a blend of quant and active. You do this by following a rules-based approach to portfolio management. The checklist displayed to the right is a simplistic, though effective, example of how quantitative and active approaches can be combined into a followable strategy.

At the very top of the list is asset allocation. There are complex mathematical models for how to do this, but ultimately, the proper asset allocation for each person requires active involvement. No mathematical formula can convey the fear you will feel when a bear market causes your net worth to plunge. For most investors, the correct allocation involves an allocation to stocks just below breakpoint where they panic and abandon their strategy during a bear market. Strategies such as keeping a buffer in cash (e.g., one to four years of living expenses for retirees) can push this breakpoint upward, allowing you to allocate more to stocks.

The second step is to fill the portfolio with passive index funds, or at least benchmark to them if an active approach is preferred. Diversified, widely followed index funds (e.g., the S&P 500, the Russell 2000, etc.) should be the default choices unless you have a strategy for realizing high returns, more portfolio income or less volatility. If you are unable to achieve one of these three goals over the long term with an active fund or strategy, go passive. Index investing, which is a form of quantitative investing, has proven to a be a tough benchmark to beat over the long term.

If you want to use active strategies, create rules for how you will select and monitor investments. Regardless of whether you intend to buy individual securities or actively managed funds, have a clearly defined process for how you will identify them, analyze them and determine when it is time to sell them. These rules will take the emotions out of your decisions and will lead to higher returns. Quantitative figures (valuation, momentum, fundamental ratios, a fund’s long-term performance relative to its peers, etc.) work very well at making these rules effective.

Once the rules are created, you must follow them. This may seem like a silly thing to write, but rules only work if they are followed. The advantage of having software make decisions over humans is that software never hems and haws about whether a rules-based action should be taken. Humans can and do look for excuses. (And yes, there are times when it makes sense to break the rules, but those occurrences should be well-defined exceptions—such as selling in response to news about a company’s CEO cooking the books—and not the norm.)

The rules should also include guidelines for how and when your portfolio’s allocation will be adjusted. Fund families using quantitative strategies can have software do this for them. Individual investors can simplify the process by periodically checking allocations against the target. For example, if an asset class (or an individual holding) becomes too excessively weighted relative to your target, pare back your portfolio’s exposure to it.

Finally, think long-term. No approach to investing—be it quantitative, active or a rules-based blend—is going to work all of the time. Investing success comes from the discipline of sticking to a well-thought-out strategy regardless of whether market conditions are favorable or unfavorable.