Equilla is founded on three axioms. First, the market will always go up over time. Second, all of the assets in the portfolio have been vetted and are worthy of investment. The third and most important is derived from the work of Dr. Markowitz; namely that the combined performance of the assets in the portfolio is more important than individual asset performance.
In its simplest form “Performance Harvesting” is the practical application of Dr. Markowitz’s observation about the importance of the relationship of the assets in a portfolio. This observation is the basis for the third axiom.
This section will describe in general terms how performance harvesting works and how it is the means of asset accumulation. This paper is purposely written in general terms without any laborious statistical jargon so that the mechanics of the process can be explained in a simplified manner.
The first step in applying Dr. Markowitz theory is to view the combination of assets as the investment not the individual assets themselves. We call this combination of assets a trade group.
Stated another way, the return of the combined assets (including both negative and positive returns) is what matters.
Now, consider a simple asset group constructed of four assets; one Bond asset, one large cap asset, one mid cap asset, and one small cap asset (the later three assets together being referred to as “equity” assets and the Bond asset as “fixed”).
We can agree that in general a “fixed” asset will exhibit less volatility than an “equity” asset. Based on the relationship of risk and reward the implication is that the “fixed” asset will also generally exhibit smaller absolute returns when considered in relation to the “equity” assets.
Now let’s consider the four assets not as individuals but as a unified investment, a tiny portfolio if you will. This is what we call a “Trade Group”. As time progresses all of the assets begin to exhibit returns in varying degrees. At some point Equilla will determine that there is sufficient performance present in the assets as a group to warrant being “harvested”. This will cause trades to be generated. Equilla will sell higher performing assets within the “Trade Group”, thus converting unrealized appreciation to realized gain, and use the proceeds to buy shares of under performing assets within the “Trade Group”. Notice that performance is harvested and reapportioned exclusively within the “Trade Group”.
Since Equilla views all four assets as a single investment entity she does not care in what proportion the assets in the group are held. Relying on the second axiom (all assets have been vetted and are investment worthy) Equilla is free to hold any of the four assets in whatever proportion is deemed appropriate based on their performance.
Equilla, will periodically “harvest performance” within the “Trade Group”, by taking a portion of the unrealized appreciation and reapportioning it to all of the assets in the “Trade Group”. This inevitably will mean selling shares from one or more of the assets to “realize” the appreciation so that it can be reapportioned.
You may recall in our example “Trade Group” we have one “fixed asset” and three “equity assets”. Since “equity assets” generally produce more unrealized appreciation than “fixed assets” the performance reapportionment in most cases will flow from the “equity assets” (in varying degrees) to the “fixed asset”. The example uses actual assets and prices from November 2017 to February 2018.
As time progresses the Equity assets (IJR, IJH and GOOGL) continue to rise in value from $434.47 (Blue) to $447.39 (Yellow) and to $485.33 (Green). Each time that Equilla trades she reapportions performance between the assets by selling over performing assets and buying under performing assets within the trade group. Equilla is “Selling high and buying low”.
Over this period the MWTIX has continued to be the under performer so it has been the beneficiary of the performance transfer. In fact, MWTIX is negatively correlated with the S&P 500 so as the “Equity” assets increased MWTIX decreased slightly allowing Equilla to maximize her buying power. As we know however assets don’t go up continuously.
So, on February 5th when the “Equity assets” finally drop in value the harvesting algorithm actually transfers performance from the MWTIX (which is now a relative over achiever) to the “Equity assets”. This is an over simplified statement but MWTIX has acted as a kind or “performance bank”.
Notice that in the example which uses actual prices, the average price of assets harvested (sold during the November to January run up) is $455.73. The average price of assets reinvested (bought at the February 5th sell off) is $440.43 for an average gain per share of $15.30. Equilla was “selling high and buying low”.
This continual process of accumulating performance within the group (axiom 1) and reapportioning it (axiom 2) results in the accumulation of shares in all of the assets in the trade group. All of the assets in the “Trade Group” move forward together; sharing in the combined performance of the “Trade Group”. Because over and under performers continuously switch places and because Equilla continuously sells high and buys low you are assured that over time more shares will be acquired in every asset without ever having to add money to purchase the shares.