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Kinniry: A Double Hurdle for Tactical Asset Allocation

Jeffrey Ptak, CFA

Jeffrey Ptak: I'm Jeff Ptak, coming to you from the sixth annual Morningstar ETF Conference here in Chicago.

I'm very pleased to be joined today by Fran Kinniry. He is a senior investment strategist and principal at The Vanguard Group--a thought leader for Vanguard.

Fran, thank you very much for joining us today.

Fran Kinniry: Thanks, Jeff. Appreciate it.

Ptak: Fran, you participated in a panel at the conference entitled, "Can Tactical Asset Allocation Work?" So I'll put that question to you directly: Can it work?

Kinniry: I think, the active management space in general, active can work. Tactical asset allocation can work, but then you get into the idea of probabilities of success. So we do know in zero-sum games and counterparties, mathematically half can outperform, half can underperform pre-costs. And then after-costs, it tends to skew it to where a small minority can work.

So, if you look at the research and the data, 10%, 20%, 25% on any cycle have been successful, but then you have to ask yourself, "Is there persistence?"

Ptak: How can an investor enhance their odds of successfully choosing a dynamic asset allocation strategy? Are there rules of thumb they could follow?

Kinniry: With manager selection in long-only, or in the regular mutual fund space, you really want to understand the philosophy, the people that are involved, and then lastly what are the costs to investing in the strategy? If you really have confidence in the people, the philosophy, and it's at a reasonable cost to overcome the friction, then that would be my criteria.

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Ptak: One of the things you've written about recently is not just the difficulty associated with tactical asset allocation, but also the difficulty associated with investing in such a strategy. Many of them are contrarian by nature, and so it can be difficult to stick with those types of strategies when they hit a bout of adversity.

Can you talk about that and some best practices that investors interested in these types of contrarian strategies might want to consider before they invest?

Kinniry: Even if you get the investment part right, and the asset manager is doing a good job, then you have the second component, which is, "Are investors going to stick with it?"

We do know that markets go through deep cycles, and bull markets don't give you a clear signal as to when they're going to end, or when bear markets are going to end. So by definition, if you're using most valuation metrics--meaning you're trying to buy cheap or sell rich--it's going to be contrarian to what most cash flow is doing and really contrarian to your own intuition.

And typically you're going to be early, so you or your clients are going to be going into a spot that most others aren't going into. It's probably not going to work for some time; it's going to be against intuition. And so I do think investors have a double challenge here when it relates to tactical allocation, and that is, can they hold with it long enough to be successful?

Ptak: Vanguard at one time had its own dynamic asset allocation strategy; it was the Asset Allocation fund, which was merged into another of your offerings back in 2011. Can you take us through the thought process that informed the decision to merge that strategy away, and maybe any implications that it might have on an investor who was considering a strategy like it for their own use?

Kinniry: I would say we mostly were happy with the performance of the fund. The fund was around for over 20 years and actually had large assets under management. And I think the good thing at Vanguard, what we always do, is we are diligent about making sure that our funds still meet the requirements for investor success. At Vanguard, we actually have a core purpose, and that's to give investors the best chance of success. And we look at some of our funds, even though the performance may be good, and we ask, "Are investors using this to their own benefit?" And after looking at all that, we came to the conclusion that while it was a good offer, it had done well, and had large assets, we decided it would be best just to go into a strategic asset allocation. So we wound that fund into the Balanced Index Fund, as you mentioned.

That doesn't mean that Vanguard doesn't believe in active. We have a lot of active management--fixed income and equity--but it's more at the security level where we're making a lot of small bets as opposed to these directional bets, which, if you get it wrong even in a small 5% or 10% way, can really lead to tracking error.

Ptak: Why do you think that making tilts at the asset class level is perhaps less hospitable to an active manager than maybe bottom-up security selection would be?

Kinniry: I think the key is back to probability theory. If you buy 400 or 500 or 800 stocks, and you're plus or minus 10 basis points from its market cap-weight, hypothetically, if you get 55% or 60% of them right, you're going to outperform relative to your costs.

But if you tilt a portfolio, let's say, 5% more aggressive throughout the last 15 years, or 5% more conservative, the dispersion of stocks and bonds and the correlation of them are so wide. So, you end up with even a small bet or a small overweight/underweight blowing out the distribution. Whereas with securities, they tend to correlate pretty closely. So you're getting the overall dispersion down, and we think the best chance for active success.

Ptak: Last question: Has any of Vanguard's research shown that a tactical asset allocation strategy can perhaps nicely complement a more traditional portfolio allocation to stocks and bonds?

Kinniry: Just like we really believe in active management, if we felt there was a strong probability of us being successful, we probably would implement it. So it's not without a lot of research and a lot of effort in trying, and we'll continue to try. But as of now, we really haven't found that tactical asset allocation makes a lot of sense for our assets in the portfolios.

Ptak: Fran, thank you again for your time and your insights today.

Kinniry: Thanks, Jeff. It's always good to be here at Morningstar. I appreciate it.

Ptak: From the sixth annual Morningstar ETF Conference in Chicago, I'm Jeff Ptak.