Why Tactical-Allocation Funds Failed—Again

The past few years should have been a great time for tactical-allocation funds to prove their worth. These funds aim to vary their asset exposure to take advantage of shorter-term changes in market trends. The idea is to rotate into asset classes with better prospects and out of those that might lag if certain macroeconomic trends play out. And there have been plenty of shifts in macro trends: first, resurgent inflation in 2021, then a rapid-fire series of interest-rate hikes and a bear market in both stocks and bonds in 2022, then a market rebound in 2023, followed by widespread expectations for multiple interest-rate cuts the following year, and then continued economic strength and a higher-for-longer rate environment in most of 2024.

But instead of taking advantage of the shifting landscape, most tactical-allocation funds have been on the wrong foot more often than not.

The Results

As shown in the graph below, the average tactical asset-allocation fund has consistently underperformed more static asset-allocation funds. (I used the moderate-allocation Morningstar Category for comparison because its risk profile and target equity allocation range of 50% to 70% of assets are generally in line with those of the typical tactical asset-allocation fund.)

When compared against the average fund in the moderate-allocation category, tactical asset-allocation funds have lagged by more than 2 percentage points per year, on average, over the past five years. They’ve trailed by roughly twice that amount when compared against a simple portfolio composed of 60% stocks and 40% bonds and rebalanced annually.

Things don’t look better over longer time periods. Over the trailing 20-year period, tactical-allocation funds have generated annualized returns of about 5.0% per year, compared with 6.4% for the average moderate-allocation fund and 7.8% for the basic 60/40 portfolio.

These funds haven’t reduced risk, either. As shown in the scatterplot below, they’ve actually taken on slightly more risk than both moderate-allocation funds and the 60/40 portfolio while generating lower returns.

The Cause

What’s the reason behind this lackluster track record? Basically, tactical-allocation funds have failed to deliver on the very thing that they’re supposed to do well: adjusting their asset allocations to adapt to changing market conditions.

As shown in the graph below, the typical fund in this category increased its equity exposure as the market recovered following the covid-driven market correction in early 2020. Most funds in the category were therefore heavily exposed to the next market drawdown in 2022, when stocks dropped nearly 20%. They did reduce their bond exposure slightly during 2021, but not enough to avoid double-digit losses as interest rates sharply increased in 2022. By the end of 2022, equity exposure had dropped to about 40% of assets while cash rose to nearly 29%, which was exactly the wrong position for the subsequent market rebound in 2023.

The chart below, which plots the average equity exposure as of the end of each year along with equity returns over the following 12 months, shows another view of how poorly timed portfolio moves worked in practice.

As Jeff Ptak wrote in a previous article, the subset of tactical-allocation funds that he examined would have earned twice as much if they simply maintained a static asset allocation over the 10-year period he examined instead of adjusting their portfolios during that time.

High costs have also weighed down results for tactical asset-allocation funds. On average, funds in this category levy annual expense ratios of 1.4% of assets, making them one of the pricier categories in Morningstar’s database. Because fund expenses come directly out of returns, high costs are a contributing factor behind their disappointing returns.

Performance would look even worse if it included results for funds that were merged or liquidated. Tactical asset-allocation funds have an unusually high mortality rate: Morningstar’s database includes a total of 243 unique funds in this category (not including multiple share classes), but 126 of those no longer exist. Funds with weaker performance often quietly disappear, which has the effect of making results for surviving funds look better. And the differences in performance can be significant. Including results for obsolete funds, annualized returns for the trailing 10-year period would drop to about 3.8%, compared with 4.3% for only the funds that remain.

Exceptions to the Rule

Granted, tactical asset-allocation funds haven’t been an unmitigated disaster. A few funds have been able to implement tactical approaches with a degree of success. For example, AQR Multi-Asset AQRNX uses a risk parity approach to balance risk between stocks, bonds, and inflation-sensitive assets and also makes tactical shifts based on AQR’s models for value, momentum, quality, market sentiment, and other factors. Columbia Thermostat COTDX has also generated solid returns by automatically adjusting its level of equity exposure based on changes in equity market valuations.

Some target-date fund series, such as T. Rowe Price Retirement and BlackRock LifePath Dynamic, have also successfully implemented tactical approaches to asset allocation. These funds typically keep any tactical tilts within a relatively small range, though, limiting the risk inherent in making dramatic portfolio changes.

Conclusion

Despite a few isolated success stories, the overwhelming body of evidence suggests that tactical asset allocation is detrimental to investors’ bottom lines. Instead, investors are far better served by funds that maintain more-stable asset mixes, as well as by avoiding the temptation to make shorter-term shifts in their own portfolios.