Can Tactical Allocation Work for You?

At the Morningstar ETF Conference, Morningstar's Jeff Ptak moderated the "Can Tactical Allocation Work?" panel. Panelists included Horizon Investments' Robbie Cannon, Vanguard's Fran Kinniry, and Windham Capital's Lucas Turton.

What is tactical allocation? Kinniry acknowledges that there are unlimited variations on the theme. But at the core, Kinniry defines tactical allocation as an active strategy that moves between or within high- and low-risk assets in an effort to enhance returns or mitigate risk. Turton summarizes tactical allocation as "an active investment decision that is built on the belief that there are macro inefficiencies in the market." In essence, these are "go-anywhere" strategies that "go" where management feels it can minimize risk, enhance return, or both.

Persistent outperformance by the U.S. stock and bond markets during the past several years, however, has left many of these dynamic strategies in the dust. Turton acknowledges that it has been challenging to argue the value of global, go-anywhere strategies in the face of consecutive years of increases in the S&P 500 and Barclays Aggregate Bond Index.

But given the threat of rising interest rates and the return of volatility in the U.S. equity market, the time may be right for tactical allocation strategies. "A lot of us in this room believe that returns going forward are going to be low," Turton says. In fact, Cannon expects a year-over-year sequence of negative returns for the bond market as rates rise. "You'll want to be able to tilt into global markets," he says. "No single strategy is going to win every single year," adds Turton. As such, having exposure to a diverse set of global strategies that have the ability to tilt toward and away from certain markets could become more valuable to investors.

The challenges for investors in these go-anywhere funds are numerous, though. The first challenge: determining what strategy or strategies you'd like to pursue. The tactical allocation category includes a hodge-podge of approaches. Some take a bottom-up, security-by-security approach, while others rotate among sectors. And some "risk parity" strategies seek to deliver returns at a preset level of volatility. (Premium Members can read more about some of the various approaches to tactical allocation

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Once you know what needs you want to fill, you need to set appropriate expectations for performance. Kinnery warns, "Investors need to understand that they will undergo large periods of underperformance." That's why it's critical that investors align themselves with managers whose strategies and processes they understand and believe in.

And finally, investors in tactical allocation strategies must put emotions aside, because it can be difficult to stick with these strategies. Kinnery noted that Vanguard phased out its tactical allocation portfolio several years ago, not because the fund had underperformed, but because it was misused by investors. "We had a very hard time having clients stay with it during tough times," he says. "The investor's experience--they did not do well with the fund."