Can Tactical Asset Allocation Work?

Tactical asset-allocation funds enjoyed a burst of popularity after the financial crisis. Proponents argued that tactical allocation can be valuable in bear markets or amid heavy volatility given their flexibility. Tactical managers typically eschew investing in a static mix of investments like a manager of a traditional balanced fund would. Instead, they rapidly shift between asset classes, often in following macroeconomic or trend-following strategies.

Our research has found, however, that tactical funds generally have failed to deliver better risk-adjusted returns, or downside protection, than do traditional balanced index portfolios. Granted, the recent bull market for U.S. equities made it tough for managers of tactical strategies. The S&P 500 has trounced most managers over the past few years, making it hard for them to demonstrate their value proposition.

At the 2015 Morningstar ETF Conference in October, I moderated a panel that sought to tackle whether tactical asset allocation can be a worthwhile strategy, and if so, under what circumstances. On the panel were Robbie Cannon, president and CEO of Horizon Investments, a firm that specializes in tactical asset-allocation strategies; Lucas Turton, CFA, a managing partner and chief investment officer of Windham Capital, which also runs tactical strategies; and Fran Kinniry, CFA, who is a principal in the Vanguard Investment Strategy Group. Our discussion has been edited for clarity and length.

Ptak: Just so we don't get lost in semantics, let's start by talking about how we define tactical asset allocation. Let's start with Fran.

Fran Kinniry: At the highest level, if we start with strategic, you're leaving your allocations largely the same, other than drift, and then rebalancing back to that strategy. Tactical, then, would be moving around, whether between high-risk, low-risk, or even within high-risk and low-risk, based upon some fundamental belief of relative outperformance or risk mitigation.

Ptak: It's basically modifying your policy allocation in some material way.

Kinniry: That's correct.

Ptak: Robbie, how would you define it, looking through the prism of your firm and how it is you go about your work?

Robbie Cannon: I like the definition in regards to a policy mix--and then how do you augment or change that policy mix? What metrics do you use? From our standpoint, we have to use different disciplines. What's fascinating in the tactical asset-allocation space is the amount of quantitative metrics that are used to change the policy mix.

But I also think that there are economic reasons, there are policy reasons, there are tax reasons, there are fundamental reasons to change. We're all tactical. If we weren't, we'd still be all invested in coal and railroads.

Ptak: Lucas?

Lucas Turton: The only thing I would add is that it is an active investment decision that is built on the belief that there are macro inefficiencies in the market. As Fran alluded to, they may not necessarily just be alpha. There may be benefits to greater stability in the portfolio. Mitigating risk can be a purpose of a tactical asset-allocation strategy. It is the time-varying of the beta exposures with a purpose.

I'll caution that the tactical is tilting the asset allocation to generate a better investment outcome for your client. It's not about hitting home runs.

Setting Expectations

Ptak: Part of the defining tactical is setting expectations for clients. Robbie, how do you go about that?

Cannon: Definition is really important, because, historically, tactical meant all in, all out. "Hey, we've got some sort of policy mix, and we can move completely out of that policy mix." That definition is really damaging to the space, because there are a lot of great managers who manage tactically but manage within bounds. So, from an expectations standpoint, we set risk bands. We probably all use traditional benchmarks--S&P 500 and the MSCI ACWI ex U.S. We set a 1.2 to 0.8 beta range around those. That's our constraint. You can't have a complete emerging-market portfolio. It's not going to fit in the risk bands.

Ptak: Fran, going back a few years with Vanguard, you had what might be considered a dynamic asset-allocation strategy. Can you take us back and give a sense of why Vanguard decided that it was no longer relevant to the customers that you serve?

Kinniry: Asset Allocation Fund was the name. It was started in 1988, and its assets peaked at $12 billion in 2007. The fund did very, very well. But you can have strategies that may work for 10 years, 15 years, 20 years--maybe even 50 years--and it's hard to differentiate when you have a paradigm shift.

We thought we were doing extremely well in the fund. It had 30 basis points of excess return. However, we decided to close it, not because of performance but because Vanguard's original mission is to make sure our investors do well--not just the fund doing well.

It gets to forming expectations that we've discussed here. Most tactical asset-allocation models are going to have some contrarian form to them. Most of them may be early and wrong. We had a very, very hard time having clients stay with the fund during out-of-favor periods. While the fund did well, when we looked at the internal rate of return versus the time-weighted return, which is the investor experience, investors actually did not do well. That doesn't mean that was everyone's experience. Certainly, it depends on how much you can influence your clients and educate your clients and what type of clients you're working with--that they understand that it's going to go through long cycles of underperformance and outperformance.

So, our experience was largely positive at the fund level but not necessarily positive for clients in real dollar terms.

Ptak: Putting yourself in the shoes of a practitioner who is having to go through the same kind of progression in figuring out whether a tactical strategy belongs in a client's portfolio, what should they be considering?

Kinniry: Just like active management in general, you're going to have a distribution of winners and losers. It's a zero-sum game. We all cannot be tactical in the right direction. We need a counterparty to be on the opposite side of where we're going.

By definition, you're going to have pre-cost 50% not do well; after-cost, probably 70%. That's what the Morningstar data shows. But that doesn't mean that there's not going to be a cohort of investors that do well.

Ptak: Active investing has been challenged, especially in recent years. We could say the same is true of tactical strategies as well. We've had a raging bull market. The market has narrowed to a certain extent, and some tactical strategies haven't been able to keep pace. For practitioners who are trying reaffirm their confidence in tactical investing, what argument would you offer to them?

Turton: We spend a lot of time focusing on global diversification. That's been a big headwind we've faced. The smartest thing to do three years ago was to be undiversified and own U.S. assets--buy REITs, S&P 500, and Barclays Aggregate--and you beat everything.

But we've all seen the Morningstar charts and the Vanguard charts. When asset classes stack up at the top of the list, they then often fall to the bottom of the list. The S&P 500 can't outperform year in, year out. So, we spend a lot of time reaffirming the purpose of global diversification and how it makes economic sense. You want to own all these asset classes, and then you make tactical decisions around it. As Robbie said, we're all tactical. None of us are sitting here with the same portfolio we held 10 years ago. Things do change.

So, pick an investment strategy and stick with it, and when it doesn't perform well, you have to be able to defend it.

Ptak: Fran, is there a blueprint that a practitioner should be aware of or looking for when they're trying to define a prudent tactical asset-allocation strategy?

Kinniry: I would say it looks very similar to the same criteria you would use for traditional long-only active or private equity. It's manager selection. You need to be with the right manager. You must believe in their process, their philosophy, and what they're offering, because as we've discussed, it's a negative-sum game.

One thing, strategic is not necessarily dead. If we look at our 60/40 off-the-shelf simple fund and compare it to the endowment and foundation universe--one, three, five, even 10 years back, before the global financial crisis--it's outperformed 80% or 90% of these strategies, which have alternatives, hedge funds, private equity.

But there are managers in that universe that have consistently done well--the Yales of the world. Manager selection is the key to success.

Ptak: How would you distinguish between luck and skill with a manager? What are the tells that somebody has just been on a lucky streak versus someone who has more durable qualities that will serve investors well in the future?

Kinniry: That's a tough one for me to answer. We probably need 100 years of observations to specifically say for sure that someone's independent observations are not due to luck.

Whether we want to say 50 years or 30, I'm fine, but I certainly wouldn't say that with a 10- or 20-year track record, you could differentiate between luck or skill. And that may not matter. Maybe you can't make that determination. But the key is finding the managers whose philosophy and process you believe in and whom you trust--because there are going to be managers who do this well.

Finding an Edge

Ptak: It would seem like it would also be important to identify whether there is some sort of market inefficiency—a mispricing that the manager is attempting to exploit. Lucas, what is that market inefficiency that you're trying to take advantage of and what gives you confidence that it'll persist over time, so that you can continue adding value for your clients?

Turton: That's a very good question. If you are tactical, you're trying to predict something that's going to occur. You're trying to outsmart the markets, and the markets on average are pretty smart and efficient. What we try to do is focus on areas that may not have been exploited. We publish a lot of research. I read a lot of research papers--value premium, small-cap premium. Guess what happens when you write a paper? People go out and exploit it, and that alpha generation disappears.

But the one area where we saw a lot of persistence for many, many years was in the currency market. We used risk as an indication of when we wanted to own the carry-trade and when we didn't want to own the carry-trade. We didn't look at the economics of the different countries. We just said, "When currencies are highly volatile and there's a lot of turbulence in the currency markets, the carry-trade doesn't work." And this was a pretty consistent strategy from the late 1980s into 2012.

In 2009, we began getting institutional mandates and looking at the futures markets versus ETFs. We found that we could get access to the markets very inexpensively--those betas we wanted to own--and that when we applied these same risk models, there are certain characteristics of risk that preceded risk. Risk is something that's significantly more persistent than prices.

It's just like a business cycle, where you're in contraction versus recession. If you can model risk in the same way that a business cycle is modeled, you can generate positive returns. There are not a lot of us doing that right now. It's an area that's been overlooked, because everyone focuses on valuation. Have you ever quantitatively run through a valuation? Guess what? The S&P 500 on a cyclically adjusted P/E basis is one of the most expensive equity markets in the world. You would have been out of the S&P 500 long ago, and that would have been a bad decision. Eventually you're going to be right on that call, but your clients will have left you. Valuation is tough to manage given the behavioral biases of clients.

Why does tactical work? It is investor behavior. There are bubbles. Prices exceed intrinsic value. Bubbles burst. Prices fall below intrinsic value. There tends to be momentum in that selling, when people overreact to the markets. And despite the fact we're a quantitative manager, we're taking advantage of the behavior. If you can be on the other side of those trades, you can generate alpha.

Ptak: Let's use your Windham Risk Regime III as an example. What about its position do you think best expresses the views that you just articulated?

Turton: I can give you an idea of how we're positioned. Risk Regime III's benchmarks resemble a 70%/30% portfolio. We're trying to generate that much risk. Today, we're allocated 40% to risky assets and 60% to bonds. So, we're 30% short equity markets, or risk in the market. That's an indication of how pessimistic I am about risk going forward. We're in a high-risk regime, and in high-risk regimes, you typically don't get rewarded for the amount of volatility you take.

It is a very dangerous environment. I'm not calling a market correction, because that would be market-timing. If anyone tells you they can pick tops and bottoms, that's false. But this is a risky environment. It feels a lot different this year than it did this time last year.

Ptak: Fran, I wanted to go back to something that you wrote recently. You and Vanguard put out a paper several weeks ago, the title of which is "Tactical Practical." You did so in advance of this conference, which was nice and thoughtful of you. One of the things that you discussed was the enduring nature of contrarianism. What you note is that it's difficult for investors to stick with contrarian, go-against-the-grain strategies. How does a practitioner reconcile being a contrarian and the risk of losing clients in the process?

Kinniry: We have to be clear on the definition of contrarian, because we're not talking about 2000, 2001, 2002, where we have three years in a row of the markets declining. It's not contrarian for contrarian's sake. You need to look at the fundamentals of an investment. Throughout that bear market, you actually had P/E expansion--not that P/E multiples or relative valuations are the only metric one should use, but we do know initial conditions can have influence over longer series of investments.

If you think about the fixed-income market, for example, it's almost impossible to replicate the past 10 or 20 years in fixed income with an initial handle on 10-year Treasuries of 220. We've been talking about the initial conditions of valuations on the stock market. Whether it's in the 70th or 75th or 80th percentile doesn't quite matter.

But we don't want to be contrarian just for contrarian's sake. We would say that most of the information is in the details. So, 1999--we're not near 1999 now. So, I do worry, too, that people overstretch on valuations. Most of the information is in decile one or decile 10. Two through nine is pretty much noise.

And we just have not been in those episodes since 1999, quite frankly. A lot of people think we reached bottom in 2008 in the depths of the worst day, but to get in decile one, you're in single-digit P/Es. So, we're not there in emerging markets, we're not there in Euro, and we're not there in the U.S. certainly. But we're also not in decile 10, either.

So, I think we have to define contrarian. It's not what has been the last one-year, three-year, five-year returns. You're buying an equity, you're buying the free-cash-flow stream on some valuation metric. You really should be looking at valuations as opposed to returns. But then, being contrarian, no matter how much we try to educate, investors still buy on one-, three-, five-, and 10-year returns.

It's very difficult to try to sell someone something with a single-digit P/E, because chances are it has a significantly negative one-, three-, five-year return. It is a tough challenge. It's really about educating your clients what initial conditions mean and why you're rebalancing or tactically adjusting your portfolio.

Ptak: What advice would you give to an aspiring tactical strategist out there?

Kinniry: You have to have a really good understanding of your counterparty. It's a sophisticated business. Make sure you understand the competition you're up against. The information that all of us have is well-disseminated. Technology has been the great equalizer. I was just reading the other day that they're having the global chess championship, and there's no humans playing in it. With the speed of technology and computing and the artificial intelligence that is being built into quantitative algorithms, just don't underestimate your counterparty. That's all I would say.

Ptak: Some investors, such as Jeremy Grantham, argue ardently that they see large mispricings take place at the asset-class level. Fran, does your research support that notion?

Kinniry: There are certainly asset classes that are more heavily traded and where knowledge is shared much more frequently, which could create a counterparty advantage. But again, even in the least efficient market, please understand who your counterparty is. And these markets tend to be ones that have the highest friction.

You look at research and you think you're going into timber or something that's pretty exotic with informational advantage. These markets tend to be less liquid with larger spreads. So, you just want to make sure you can execute on your informational advantage.

China A-Shares

Ptak: How about a question from the audience?

Audience member: Can you talk about China? I'm interested in how you measure risk in China and then how that informs your approach to something like China A-shares.

Kinnery: Vanguard pushes the upper limits of globalization. We've heard a lot about the S&P 500. We've never compared ourselves to the S&P 500. Most institutional portfolios use global benchmarks. Within all of our designed solutions, we're close to the global market cap.

We were one of the first to add China A-shares. We have not backed away from that due to the volatility. We're excited to have A-shares in our emerging-markets ETF. We're doing it for the same reasons why you would do globalization: We want to own the world and provide global diversification at the lowest cost.

The plan all along was to go in slow. If the market would have bubbled up, we still would have had the same strategy. It's fortunate that it went the other way, because we'll be dollar-cost averaging in at lower levels. That goes back to luck versus skill.

Ptak: Lucas, Robbie, has China informed the way you've positioned your portfolios?

Cannon: Yes. In 2014, we were about 5% international on our all-equity portfolio. We moved this summer to about 40%, including currency hedge, which I thought was the right play--you had such a dislocation in currency markets last December.

We played China from a market-weight perspective, but we've been avoiding it for probably the past six months. We stay within our risk band, so we're not going to have a whole lot of China.

Turton: There were two questions there. One, as China opens up, do we want to own A-shares? And the answer is yes, but it's contingent on costs. If the cost to transact is too high for a tactical manager that needs turnover, then we have to omit that asset class. I love timber. I love infrastructure. I can't own it, though, without having a concentrated portfolio. So, yes, I want to include as much as I can in this portfolio. I believe in global diversification, and China is a force to reckon with.

The other question is, how is China having an impact on our asset allocation? Between oil prices and China, these are two drivers of why we are so pessimistic. China is spilling over into other asset classes, and we're not finding safety by moving away from China. So, our current allocation to China is based on the percentage of China that's in the ETF. We don't specifically look at China. But we are underweight equities, which means from a global-cap weighting, we're underweight China. We're seeing real estate, oil, and China as the biggest drivers of risk in the markets today. I don't know the implications of this. In hindsight, we'll be able to determine whether or not this is some form of real estate bubble. But it has the look of a commercial real estate bubble, potentially here in the U.S. and in China.

Audience member: Are there times when you think you need to modify your approach and modeling?

Cannon: That's a great question. The reason why I got into this business 16 years ago was that I was looking for the holy grail, but I just don't think it exists. There's not a model out there that won't stop working at some point. So, I want smart people in the room trying to navigate that when it stops working, what will be the ramifications.

Take 2008, for example. Central banks became very large players in the markets; they weren't there before. You've got to take account for large changes like that. Now, you've got to start watching central banks. In the 1990s, you didn't need to. You watched  Cisco (CSCO),  Intel (INTC), and  Microsoft (MSFT).

So, certainly, we're refining our process all the time. We're not changing our process, but certainly the models underneath it.

Ptak: How do you strike an appropriate balance between continuously improving your processes and innovating, while being steadfast and sticking with it--especially in a period of time when it's under pressure, when the market has gone against you? Lucas, I'll put this question to you.

Turton: We were originally a research firm. We had no salespeople. The only reason I'm sitting before you is that the CIO of the state of Maine called back after we accidentally hung up on him because he wanted to give us a mandate. Having this research focus, we have a very high bar for making an adjustment. We have to be really thoughtful about changes that we make. They have to be intuitive and make sense, as well as be thoroughly tested. That means that the majority of the things that we're working on today won't ever make their way into our model, and I think that's a healthy way to be.

This article originally appeared in the December/January 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.