Jay D. Franklin

Tactical Asset Allocation: The Market-Timing Wolf in Sheep's Clothing

Borrowing the definition from a recent Vanguard study,

"Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances among different asset or sub-asset classes."

To put it more succinctly, TAA is simply market-timing but with only a set portion of the whole portfolio. For example, an institution may have an SAA of 60% equities and 40% fixed income, but utilization of TAA may allow the equity allocation to vary between 50% and 70% and the fixed income allocation to vary between 30% and 50%. This is equivalent to saying that 80% of the portfolio will have a 60/40 allocation while market-timing (or style-picking) will be performed with the remaining 20%. For institutional investors, TAA occurs at two levels: Investment consultants allocating funds among different asset class managers and investment fund managers allocating funds among different asset classes and sub-asset classes.

It is IFA's position that TAA is a futile exercise because market-timing and style-picking are unproductive at best, and potentially quite destructive at worst. TAA is merely one more attempt by active consultants and managers to deliver the ever-elusive alpha, which as shown in a previous article, has not been reliably achieved through security selection.

TAA is normally built on models that rely on "signals" to determine when to go heavy on one asset class at the expense of another. A well-known example is the "Fed model" which compares the earnings yield on equities to the yield on 10-year Treasury Bonds. If the earnings yield (the inverse of the price-to-earnings ratio) on the S&P 500 were to fall below the 10-Year Treasury yield, a manager utilizing TAA based on the Fed model would interpret this difference as a clear signal to favor fixed income at the expense of US equities. The Fed model, like all the other models used for market-timing, has repeatedly been shown to be unreliable in both the short-term and the long-term. For further details, see Asness, Clifford, "Fight the Fed Model", Journal of Portfolio Management, Fall 2003. Another type of signal commonly relied upon is based on market sentiment. Data points such as the amount of stock owned on margin or the amount currently sold short can be taken as indicators of whether the market is "overbought" or "oversold". Recently, The Wall Street Journal ran a column by Brett Arends entitled, "You Should Have Timed the Market" where he advocates using mutual fund cash flow data take a contrarian position from what the general investing public is doing. Of course, anyone who seriously would attempt to use these numbers to time the market would find it to be a vexing exercise because they change direction quite frequently. One problem with trying to read market sentiment for timing purposes is that sentiments can endure for years at a time. As John Maynard Keynes famously remarked, "The market can remain irrational longer than you can remain solvent."

The reason why all these models are unreliable is so simple that it is easily overlooked. In three words, prices are fair. This means that every asset class has thousands of intelligent and informed people opining daily on the risks of the asset class in general and all the securities contained in the asset class in particular. As a result of the discovery process, prices are set so that buyers can expect a return that is commensurate with the risk they assume. If an institution (or a consultant acting on its behalf) decides that an asset class is overvalued and thus should be pared back, the party taking the other side of the trade has the full expectation that they will be compensated appropriately for the risk they are taking. There is absolutely no reason for the institution or the consultant to assume that it has special proprietary knowledge that the rest of the market is lacking.

Now that IFA's theoretical objections to TAA have been outlined, it would be useful to examine how mutual funds built on TAA have performed over a long period of time. In the Morningstar Direct® database as of 12/31/2011, there are only 17 "Moderate/Conservative/Aggressive Allocation" funds that have 20 years or more of returns data. Of these 17, only 1 barely plots above the line of IFA portfolios on a reward vs. risk chart.

Figure A Chart Link

While 1 out of 17 (6%) is rather dismal to begin with, the true percentage is much lower because we are only looking at the funds that survived for the last 20 years. Given that there are 141 such funds in existence as of 12/31/2011, it is not unreasonable to assume that a similar number existed 20 years ago. In fact, this would correspond to an 10% mortality rate among these funds which is not too far from to the observed average of 7% for all mutual funds. This means that an investor who chose a tactical allocation fund 20 years ago had a less than 1% chance of both keeping the same fund and beating a risk-equivalent strategic allocation of index funds. These are not very good odds, and certainly not good enough to stake something as important as employee's retirement security or charitable funds held by a foundation or endowment.

As far as the ability of investment consultants to add value by moving funds from one manager to another, this myth was completely debunked in "Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors" (Financial Analysts Journal, Nov/Dec 2009). The authors evaluated over 80,000 investment decisions by plan sponsors (or consultants acting on their behalf). As the chart below shows, in only two out of eighteen years did plan sponsor decisions to move assets from one manager to another add value. The authors estimate that over $170 billion of investment value was destroyed over the period (1984 to 2007).

Figure A Chart Link

To summarize, TAA is simply one more attempt by Wall Street to package up luck and sell it as skill. Institutional investors are better off with a sensible strategic allocation of low-cost index funds that reflects an appropriate risk level. Market-timing and style-picking should never be utilized for either a portion of or the whole portfolio.

Roger Ibbotson was interviewed on Tactical Asset Allocation. "Investors should only consider tactical strategies when they truly have an edge, and even then, excess results are no sure thing," says Ibbotson Associates founder and Yale professor Roger Ibbotson. Please watch this video.