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Here's a Reality Check for Investors Considering Tactical Funds

Given the number of emails and calls we're getting, we're not alone in wrestling with tactical asset allocation.

Michael Herbst, 02/14/2012

Funds employing tactical asset allocation can move quickly across asset classes and/or regions, usually with the goal of avoiding losses in down markets, reaping outsize gains in up markets, or some variation on those themes. Many land in Morningstar's world-allocation or multialternatives categories, but funds with a tactical component show up elsewhere, too, such as in target-date funds. There's much debate over what's tactical and what's not. Here we'll assume that funds could be considered tactical if they have 1) declared the flexibility (but not the obligation) to invest across multiple asset classes and 2) demonstrated a willingness to adjust asset-class exposure significantly over relatively short periods of time. But like beauty, what's considered tactical is often in the eye of the beholder.

Do advisors or investors need to add a tactical fund to their portfolios? The short answer is no. The longer answer is that few are likely to stand up to the questions below that advisors and investors should ask themselves when considering purported tactical allocation funds.

What Is This Fund Trying to Do?
Given its tantalizing allure, asking what a tactical fund intends to do is critical. Many try to beat a standard asset-class benchmark (such as LIBOR, the S&P 500 or MSCI World Index, or a 60/40 split between stocks and bonds) by a stated margin or try to garner those indexes' returns with less volatility. Others invest across multiple asset classes to meet another goal, such as providing emerging-markets exposure or keeping up with inflation. Still others try to protect investors against severe market downturns.

Unfortunately there's not yet an easy, quantitative way to identify tactical funds or classify their strategies. Morningstar's ETF team has taken a helpful approach in analyzing managed ETF portfolios by beginning to tag those portfolios as strategic, tactical, or hybrid. That approach isn't yet directly applicable to mutual funds, but it does provide a basic framework for distinguishing tactical funds from the rest. Many tactical funds describe their tactical or dynamic asset-allocation approaches clearly in their marketing materials or prospectuses, which often state the funds' intended asset-allocation ranges. Those ranges can be broad, but a fund like Leuthold Global GLBLX whose prospectus says it can invest 30%-70% of assets in equities and 30%-70% in fixed income and focuses on capital preservation is going to look and perform differently from many tactical funds that can invest 0%-100% assets in any asset class. There's no single right answer to this question, but if you can't answer it in plain English, skip the fund.

What Is This Fund Actually Doing?
In many cases, you won't be able to tell what a tactical fund is actually doing to pursue its goal. Tactical funds are apt to adjust their holdings quickly and in many cases dramatically, so it's tough to know exactly what the fund owns or is exposed to at any given time. Many adjust their market exposure by taking long and short positions with derivatives such as futures, forwards, and options, as well as interest rate, credit default, and total return swaps. Derivatives themselves aren't necessarily problematic because managers can use them to adjust portfolios more nimbly and cheaply than they could by buying and selling stocks and bonds. But derivatives markets can seize up, and managing long and short positions can be difficult in volatile markets, which is when tactical funds are supposed to shine. Managers can get burned by how they invest the collateral backing those positions; many firms, including Morgan Stanley, Legg Mason, and GMO, learned that the hard way in 2008 when securities they viewed as "cash equivalents" turned out to be anything but.

Given the complexity of many tactical strategies, it can be difficult if not impossible to tell how a tactical fund is invested by looking at its portfolio holdings or the conventional asset-allocation data that many managers provide. Tactical fund managers would do right by investors by providing monthly asset allocation in two ways, side-by-side--one based on the market value of the portfolio's holdings, and one based on the fund's economic asset-class exposures. Managers also ought to break out funds' long and short asset-class exposures rather than reporting only the netted exposures and to detail how much of those exposures are in cash securities versus derivatives. Only that level of disclosure would give investors a meaningful snapshot of the fund's portfolio and its risks. Some firms' disclosure is pretty helpful, such as PIMCO's and AQR Risk Parity's AQRIX, but there's plenty of room for improvement across the board. If the fund's provider doesn't make clear and timely asset-allocation data readily available, there's no way for you to really know what it's doing. Skip the fund.

Are the Managers Any Good?
Many tactical fund managers employ complex strategies and sport short track records, making it tough to assess how effectively they're plying their strategies. We're skeptical of historical back-tests because what could have happened in the past and what actually will happen in the future are two very different things. For instance, risk parity strategies are based in large part on leveraging up exposure to bonds; that trait and their back-tested performance look great over the past 20 years when interest rates were generally falling. But now with rates at historical (and many would argue artificially depressed) lows, how much sense does it make to be taking outsize bets on bonds?

The results of many tactical managers are not impressive. Launched in January 2005, UBS Dynamic Alpha BNAAX has thus far fallen far short of its goal of outpacing inflation. The AllianceBernstein Retirement Series of target-date funds uses a volatility management tool to tactically adjust the funds' market exposure, and its management reduced the funds' equity market exposure by nearly 20 percentage points in 2011's volatile third quarter, only to miss out on part of the fourth quarter's rebound. Ivy Asset Strategy WASAX navigated 2008's downturn and 2009's rebound pretty well, only to reportedly trigger May 2010's flash crash and land on the wrong side of the markets in 2011. If you can't determine how well a tactical fund has achieved its own goal based on its performance, skip it.

Michael Herbst is an associate director of fund analysis with Morningstar.
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