James Osborne, CFP, of Bason Asset Management fears that “tactical asset allocation” will be the financial advisor profession’s “next great embarrassment.” Osborne tweeted that opinion last week in reaction to a report published on MarketWatch under the headline: “The label advisers love.”
The article, written by Charles Passy, suggests that a growing number of Wall Street pros market themselves as “tactical” investors. Traditionally, tactical investing meant that a money manager would shift assets from one asset class to another to either avoid trouble or take advantage of an emerging opportunity.
But the problem now, according to some critics, is that so many money managers have adopted the “tactical” label that there is confusion as to what it truly means, writes Passy. In July, for instance, Ron Surz wrote that he too was confused by the tactical vs. strategic asset allocation labels.
Now investors may or may not be confused. But what is true according to advocates of tactical asset allocation (TAA) is that there are benefits to the strategy. For instance, Wes Gray, Ph.D., a managing member of Empiritrage, says TAA offers the potential for enhanced returns, the potential for better risk management; and the potential for broader portfolio diversification.
That’s not to say there aren’t negatives associated with TAA. For instance, Gray says TAA comes with higher transaction costs; higher taxes; and higher management fees. Others agree. Peng Wang, CFA, an investment/quantitative analyst at Georgetown University Investment Office, says the following negatives typically apply to TAA: turnover, transaction cost, and tax if applicable.
In the main, however, Gray offered this assessment of TAA. “The benefits can enhance your portfolio,” he says.
But there are some caveats. You have to pay for the extra management. And the decision to pursue a TAA model makes sense when one can identify a TAA that enhances returns, but comes at a low cost.
“Most people peddle TAA systems and charge 1.5-2% management fees,” says Gray, who is also an assistant professor of finance at Drexel University. “In a zero interest rate environment, where risk can be expected to earn 400 to 500 basis points over LIBOR, it is hard to justify fees that account for half the risk premium.”
For the record, Gray recently published a paper pitting some of the more popular TAA models against one another in a horse race to determine which strategy has historically performed the best. “There is no shortage of tactical asset allocation models in the marketplace, nor is there a shortage of salesman willing to charge hefty fees for unproven, ad-hoc, and often ill-conceived shell games,” he wrote in his paper.
In the paper, Asset Allocation Model Horse Race, Gray presented the performance of eight different models applied to the “IVY5” asset classes (Domestic equity, foreign equity, long bonds, commodities, and REITs): Risk parity (RP) and risk parity with/without a moving average rule; Momentum (MOMO) with/without a moving average rule; Risk parity and momentum (RP_MOMO) with/without a moving average rule; and Minimum variance (Min Var) with/without a moving average rule. His conclusion:
“After the dust settles, the top performing TAA model is the risk parity with momentum model,” Gray wrote. “This model starts with the risk parity benchmark weights and then shifts weights across asset classes depending on relative momentum. The RP_MOMO model works the best with and without MA rules applied. Applying MA rules optimizes performance.”
For his part, Wang says he prefers the valuation based mean-reversion type strategy. “The advantages will be improved risk adjusted return over the long run and better downside protection,” he says. “I would suggest more disciplined systematic approach.”
Others also agree that there are pros and cons to TAA.
“Tactical asset allocation is often thought about as a kind of market timing, and so one should use it to the extent that one thinks that market timing can add value over and above an ordinary asset allocation,” says Bruce Chadwick, director of Chadwick Global Research and Consulting. “People tend to be more interested in TAA when markets are moving sideways or have crashed recently, because there is the possibility of shifting out of certain asset classes when there are large downturns in individual markets, and that is attractive. When there is a bull market in everything, the benefits of shifting around are much harder to see and most people would simply like to ride whatever's going up the fastest.”
There are some differences between pure market timing and tactical asset allocation, says Chadwick. “Pure market timing tends to be about a single asset class, and decides whether to be all-in or all-out of that market,” he says. “Tactical asset allocation diversifies its approach across several asset classes (at least stocks and bonds, and possibly others as well) and does not have to make an all-in-or-all-out call - it can involve simply overweighting one asset class a little (or a lot) more than normal. Having multiple asset classes also means you are effectively making more investment decisions at each point in time, which is itself a kind of diversification.”
Others advisors meanwhile are not so fond of TAA. Stewart Richardson III, ChFC, CRPC, of SunRay Advisors recommends avoiding tactical/timed allocations except in the most predictable and extreme of situations. Examples of those situations include long-term bond funds, where rates will rise and NAVs will fall or tech stocks in the internet bubble when valuations were ridiculous. By contrast, speculating on Greece, or election, and the like, however, is just market timing or gambling, says Richardson.
“My belief is that tactical/other ‘new normal’ tenet strategies are not time tested, and,” says Richardson, “go against the research saying no to market timing.”
For those who do want to do timing, however, Richardson’s recommends the following: Have a solid diversified foundation portfolio and allocate no more than 10% of portfolio for market timing. “And when/if that 10% is gone, do not re-fund that portion,” he says. “People are too quick to abandon buy/hold/rebalance diversified portfolios lately.”
There are, of course, those who think TAA won’t be the profession’s next great embarrassment: “Bad active managers failing have existed for centuries,” Michael Kitces tweeted last week. “Not much new embarrassment risk IMO. :-)”
To be sure, this debate over TAA and whether it’s the profession’s next great embarrassment won’t be settled anytime soon. But this much we know: The tweets about the merits of TAA continued unabated last week: Tactical Asset Allocation for Passive Investors and Tactical Asset Allocation Can Be Successful - With the Right Model are among the tweets we found.