Tactical asset-allocation funds continue to draw in assets, but not all investors will be comfortable with their broad mandates.
It's no secret that achieving long-term financial success requires discipline. Investors have spent decades carefully constructing and rebalancing diversified portfolios of stocks and bonds, seeking to strike the perfect balance. After the financial crisis debunked this formula for diversification, advisors began incorporating alternatives into the mix, allocating 5%-20% out of their traditional 60% stock/40% bond portfolio. More recently, however, investors have found themselves confronted with a new asset-allocation conundrum: tactical asset-allocation funds.
Often referred to as "global macro" or "flexible mandate" strategies, these funds rapidly shift between asset classes to take advantage of short-term market opportunities or perceived differences in relative value. They are quickly gaining ground in the multialternative category; at least six funds representing nearly $4.5 billion in assets have launched.
The Pros and Cons
For investors, the obvious advantage to these strategies is that the manager can tilt a relatively static portfolio toward areas of the market exhibiting the most return opportunity, saving investors the hassle of keeping up with the markets and rebalancing their portfolios. Proponents also argue that tactical allocation funds can be valuable in bear markets or amid heavy volatility, because the managers can sidestep trouble and move to cash.
On the flip side, market-timing is extremely difficult to execute successfully on a consistent basis. One large, bad bet could be devastating to a portfolio and an investor's wealth--in 2011 for example, one of the hedge fund industry's most renowned global macro managers, John Paulson, lost over 50% in his leveraged Advantage fund after poor bets on the United States economic recovery. In addition, because the manager can dramatically shift the portfolio's composition, it's difficult for investors to assess whether the manager is adding value. What is a good benchmark for a fund that can invest in any asset class, long or short? Simply put, in a world of balanced investing, allocating to these go-anywhere funds can be challenging.
Nonetheless, there are a couple of tactical asset allocation funds worth pointing out. Both hold a Morningstar Analyst Rating of Neutral owing to the uncertainty of their portfolios and future prospects relative to the category. However, each one has some unique features that help set it apart. For investors willing to take a chance on a go-anywhere fund, these two are among the better options.
Nuveen Tactical Market Opportunities
This global macro mutual fund invests both long and short in different asset classes and market sectors using futures contracts, exchange-traded funds, and individual securities. Comanagers Keith Hembre and Derek Bloom conduct top-down fundamental analysis on equities, credits, commodities, interest rates, and currencies and allocate to areas they expect will outperform. Cost efficiency drives implementation, and returns are generated primarily through tactical asset allocation rather than individual security selection. Management targets a return of 400 basis points above U.S. Treasury bills and an annualized volatility below 10%.
Since its December 2009 inception, this 4-star fund has definitely met those goals. It has generated 4.5% annualized, roughly 200 basis points more than its peer group (using monthly data through May 2013). In addition, the fund's standard deviation over this period falls well below its target and the multialternative category average.
The quality of the management team drives these good returns. Whereas many tactical asset-allocation funds have popped up since 2008, very few have management teams qualified to make global macroeconomic calls. This fund's captains Hembre and Bloom previously managed similar multi-asset class strategies at FAF advisors (a subsidiary of U.S. Bank), and lead manager Hembre is an experienced economist. He previously worked in the banking studies group at the Federal Reserve Bank of Minneapolis and taught economics at the St. Petersburg University of Economics and Finance.
UBS Dynamic Alpha
Another four-star fund in the multialternative category, UBS Dynamic Alpha, takes a similar approach. This opportunistic, multistrategy fund also invests both long and short, in futures and forward contracts, options, swaps, and individual corporate bonds. Portfolio managers Curt Custard, Andreas Koester, and Jonathan Davies allocate across market directional trades (net long or net short trades in equities, credit, and interest rates), relative value trades (capitalizing on a mispricing between two asset classes), individual security selection trades, and currency trades. Like most tactical allocation funds, management isn't subject to any portfolio constraints, but it targets an annualized standard deviation of 7%-10%.
So far, this unconstrained mandate has served investors well. During Custard's tenure (April 2008 to May 2013) the fund has returned 3.2% annualized, outpacing the typical multialternative fund by nearly 300 basis points, thanks to heavy allocations to equities and high-yield debt post-2008. The fund's 2012 performance deserves special mention. It returned 14.0%, better than almost all other multialternative funds, because of its long directional exposure to risky assets in general as well as several relative value international equities trades.
The management team's investment process and trade accountability are what sets it apart from the rest, however. Two analysts must propose and cosign each portfolio trade, and the outcome affects their annual bonuses. This process should prevent any excess risk-taking and should help to align management's interests with fundholders' going forward.
Lastly, both tactical funds hold one more big advantage over peers: reasonable fees. Nuveen Tactical Market Opportunities and UBS Dynamic Alpha charge annual report net expense ratios of 1.09% and 1.36%, respectively. Both fall in the category's cheapest quintile when compared with similarly distributed alternative funds (institutional and front-load). Given that expenses can run particularly high in the multialternative category (the average net expense ratio comes in at 1.76%), more-competitive fees may give these two flexible funds a leg up on pricier peers in the long run. Whereas a manager's skill and returns can ebb and flow, Morningstar has found that low cost is one of the best bets an investor can make.