_{Originally posted 03/10/2021}

Many of us have heard the data that it is very difficult to outperform the broad market index over time. While many mutual fund managers dedicate their life mission to this goal, few succeed.

There was good reason to believe Ryan Jacob would be one of the success stories in the actively managed mutual fund business. After eye popping success running the Kinetics Internet Fund from 1997 – 1999, he decided to launch his own fund, The Jacob Internet Fund. At 29 years old, he was one of the youngest individuals to ever launch a mutual fund.

Here are the annual returns of the Kinetics Internet Fund under his tenure:

1997: 12.74%
1998: 196.14%
1999: 216.44%

A $10,000 investment in the fund on 01/01/1997 was worth $105,648 by the end of 1999. Unfortunately for Ryan Jacob, his new fund launched near the peak of the dotcom bubble. Here are the returns for the first 3 full years of The Jacob Internet Fund:

2000: -79.11%
2001: -56.40%
2002: -13.04%

A $10,000 investment in the fund at the start of 2000 was worth $792 by the end of 2002, and an original investment on 03/01/2000 would not have been back above water until the end of June 2020.

Believe it or not, The Jacob Internet Fund still exists. From the start of the century through February of 2020, it has earned 4.37% annualized compared to 7.03% for the Vanguard Total Stock Market Index (VTSMX). Further, it was more than twice as volatile.

Why Does This Matter?

Your first thought might be “I’m glad I didn’t own The Jacob Internet Fund”. But what if I told you that owning a combination of The Jacob Internet Fund and the Vanguard Total Stock Market Index would have performed better than either fund individually? You might think I’m crazy, and if so, you need to keep reading.

I came across the Jacob Internet Fund not too long ago, as he is once again performing well with growth stocks going bananas. While his long-term results would be best described as mediocre, I noticed the fund’s returns were highly volatile. I remember a research piece I read about 5 years ago from EconompicData, which showed that even assets with low or negative returns can benefit a portfolio if they lack correlation with other assets and exhibit high volatility.

In the post he shows how an asset with a -5% expected annualized return would be better for a portfolio than one with a 3% expected annualized return, due to higher volatility and a monthly rebalancing strategy.

The Test

As stated above, the Vanguard Total Stock Market Index earned 7.03% annualized from 01/01/2000 – 02/28/2021. The Jacob Internet Fund earned only 4.37%.

Now, if we had put 75% in the Vanguard Total Stock Market Index and 25% in the Jacob Internet Fund what would you have expected the annualized return to be? Most people would crunch a calculation such as (.0703*.75)+(.0437*.25) and get about 6.27%. But you’re reading the Meredith Wealth Planning blog, so you aren’t most people!

I failed to include one detail, we will rebalance the allocation back to the 75/25 mix annually. This produces an annualized rate of return for the 75/25 mix of 7.78%, which is higher than either of the funds individually. How is this possible? For one reason, I data mined it, but for the other reason…..

The Rebalancing Bonus

What you have above is an example of a bonus return from rebalancing assets. As the Vanguard fund drifted above its 75% target, you sold some to buy more of the Internet Fund. As it drifted below its 75% target, you bought some from selling a portion of the Internet Fund.

This is one thing I do regularly that seems to drive a few clients crazy. “Mark, why are you selling assets that have performed well to buy those that haven’t done as well?”. Hopefully now you know why, a systematic approach to rebalancing is a way to most importantly control the risk exposure of the portfolio and try to accomplish the goal of “buy low, sell high”.

Whether or not one should expect an increased return from systematically rebalancing is debatable, but if you have a portfolio of investment assets that are not perfectly correlated and have a reasonable amount of volatility, your odds might be better. William Bernstein wrote about this exact topic over 20 years ago, so I wouldn’t consider it earth shattering. He showed an annualized rebalancing bonus of 0.49% from 1926 – 1994.

It’s important to focus on the overall portfolio strategy and not the individual parts.

Practical Application

The above mentioned funds are not recommendations, as I generally will stay away from actively managed funds like the one Mr. Jacob runs, but I wish him well.

Three factors I target with portfolios here are size, value, and momentum. These three factors do not have a perfect correlation with one another.

Avantis launched their small cap value ETF in October of 2019 (AVUV). Imagine at that time you placed 50% of your portfolio in AVUV, and to diversify you placed the other 50% in Ishares Momentum Fund (MTUM).

From 10/2019 – 02/2021 AVUV has grown at an annualized clip of 25.30% while MTUM has at 25.94%. A 50/50 approach with quarterly rebalancing has grown at an annualized rate of 28.15%, beating both assets individually.

In a taxable account you may want to consider a different approach to rebalancing, such as tolerance bands. Constantly selling winners and buying losers in a taxable account could create unwanted short-term capital gains.