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An Example of the Perils of Tactical Asset Allocation

January 14th, 2009 · 11 Comments

Reading through the Management Discussion of Fund Performance for the Accumulus Talisman Fund reveals a textbook example of a major problem with tactical asset allocation: your call might eventually prove to be the right one but the market could still move against you. Recall that in 2006 the fund returned -11% compared to 19% for the S&P/TSX 60 Index. Here’s how the report explains the fund’s under performance:

Initially, the early months of 2006 were characterized by strength, especially in the TSX as the influences that drove the market in 2005 continued to spill over in the early months of the year and the Fund stayed with the investment profile which had worked so well in 2005. By late spring, however, the market began to slip back although initially not enough that protective measures were thought necessary to be taken. By late June, however, our metrics flashed a preliminary overall ‘sell’ signal. Given our concerns based on strong
historical parallels, we took action to forestall any further downside risks, using index futures contracts to freeze the Fund’s asset value until we could determine whether or not that signal was good or not. Notably lacking (then as now) was any significant upside potential in the Financial Sector, so the fund did not hold any weighting there.

As is sometimes the case after a sell signal is rendered, the market may have a rally before heading lower, and therefore we maintained our hedge position when, in retrospect, it would have been better had we unwound it. Nevertheless, we continued to perceive growing market risks such that we created a synthetic short position for the Fund overall using index options late in the year. We did so because our proprietary value investing approach to stock selection demonstrated fewer and fewer true opportunities as time went on which is normally a signal to us that markets are on very thin ice. One of the positive aspects of our analysis
was that we had assiduously avoided the income trust sector (save one holding) because of its questionable value. Therefore its collapse late in the year did not hurt the fund as it did for many others.

Overall, 2006 turned out to be a poor year for the Fund relative to our peers in the Canadian equity mutual fund universe, in sharp contrast to 2005 in which the Talisman Fund stood in the top decile of all fund managers. While in retrospect, we might have been less aggressively bearish in our management approach, at no time did we feel that our actions were inimical with the goals of the fund, nor that our overall analysis was necessarily wrong.

After a bruising and brutal bear market, many staunch buy-and-hold investors are starting to lose faith and wondering if market timing is the answer. They may want to keep in mind the usual experience of market timing typified by this example.

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11 responses so far ↓

  • 1 EconStudent // Jan 14, 2009 at 11:56 am

    Trying to market time every year seem to be not worth the effort.

    However, understanding systematic risk, understanding general economic situation, and understanding human psychology are very important. 2008 was the year that systematic risk went over the roof and many of those who understood systematic risk left the market or shorted the market. Unfortunately, I did not understand systematic and thought buying more at lower prices was a good idea. It is a lesson that I will learn for life.

  • 2 Fred // Jan 14, 2009 at 12:00 pm

    CC:

    I wonder if the last sentence in your post was bait for me!

    The mistakes made by these folks does not provide proof-positive that market timing doesn’t work. Their efforts in this particular case did not work. That’s it.

    Market timing isn’t for everyone. Even when you have a timer that works well, the psychological side of timing is challenging.

    My US timer told me to get out the market on June 11 and my Canadian timer told me to get of the market on June 12. We all know what has happened since!

    I should add that it is easier take full advantage of market timing when you are managing a personal portfolio as compared to a mutual fund.

    Fred

  • 3 Canadian Capitalist // Jan 14, 2009 at 12:19 pm

    Fred: I wasn’t trying to bait you at all. I’ve been reading a lot of commentary by buy-and-holders questioning the wisdom of their strategy and tempted by the alternatives such as market timing. These investors who think that the grass is greener on the other side may want to keep in mind that market timing doesn’t always work as shown in this example.

  • 4 Sampson // Jan 14, 2009 at 2:13 pm

    I’m a stalwart buy-and-holder, but I’ve found that there are many instances where it seems timing is critical (in this particular market).

    Let me use a conundrum I’m currently facing re: TFSA’s. I’m going to transfer assets in-kind, so no real gains/losses. However if I transfer assets on day 1, I might get 100 units in. If I transfer on day 2, I might get 90 or 110 units in depending on the particular swing in the market that day.

    So… in essence, I am trying to time the market, but I’ll maintain the holding. Now I just wish I knew something about timing the market… ;)

  • 5 Joe Nobody // Jan 15, 2009 at 1:37 am

    I am a novice investor in knowledge. Over the last year i have read many books and have done a lot of on-line and other research into market timing – vs the “buy/hold/dollar cost avg/re balance” Strategy.

    I feel you need to Time it a little even if you lose a little on the way up and down. With my little knowledge I rebalanced my portfolio about 16 months ago. I also spread it out into as many different products offered as i could. I kept hearing 2008 was going to be bad for equities from so many sources that I felt I had to do something. I have a decent little portfolio with work where i can shuffle funds from one class/type to the other for no cost when i want. So that makes it easy for me.

    I have only lost 14% of my portfolio’s value over that period. I consider that pretty fortunate, other employees in the same group plan have lost up to 60% in aggressive portfolios.

    There are 4-5 funds available to me in our group plan that have lost 50% of their value, I’m going to buy some of those up at this new low value (transfer over) as soon as see some signs we are climbing back out of this. Even if i miss out on 10% of gain to be sure things are going forward I intend to ride those back up to to their previous levels. I won’t be greedy and will re balance once the funds get back to the level they were at or there are signs of possible other moves to protect or to make a better return.

    To me a lot of these mutual funds are simply dogs. They just give you enough to beat interest bearing investments. The Mer’s on a lot of them are ridiculous. The only people truly making money are the fund managers and brokerage companies. They prey on the lack of investor knowledge and do very little for the individual. I mean why would they? If you work for London life for example who are you really trying to make money for? Yourself and your bosses first of course.

    Even now the strategy is still the same, keep buying, stick with the plan because the unit values are low, “sorry sir yes i know, your million dollars is now $500,000″, no big deal, stick with the plan.

    Please someone tell me how this strategy really works? Why are so many financial planners unwilling to just tweak peoples plans? I’m not saying trade it like a stock but is it so bad to re balance to be a little defensive for a time and aggressive when times are better?

  • 6 Dave // Jan 15, 2009 at 5:28 am

    There’s nothing wrong with trying to time the market necessarily. If there were no fees, assuming you were diversified and tried to “time the market” many times, things would average out and you’d get the market return. It’s the fees that kill you.

  • 7 Dividend Growth Investor // Jan 15, 2009 at 12:53 pm

    Unfortunately it is true that most fund advisers only care about generating as much commissions and fees for their companies as possible. I did have some faith in the hedge fund community, but the more I hear about their 2/20 structure the more I am convicing myself that doing it all on your own will produce the best results in the long run.

  • 8 EconStudent // Jan 15, 2009 at 9:40 pm

    Joe: Nice job. You are somebody. Very nice post. By the way which books did you read?

    Here is the trailing commission schedule of a bank’ mutual fund line up:

    index funds: .25% (MER: 1%)
    fixed income funds: .50% (MER: 1 to 1.25%)
    balanced funds: .75% (MER: 1.5%)
    equity funds: 1.25% (MER: 2.5%)

    According to RedFlagDeal forum post, financial planner (mutual fund sales person) gets 65% to 85% of the trailing commission. Equity funds’ trailing commission is 5 times higher than index funds.

    According to my understanding, corporate funds have lower MERs, because they do not pay trailing commission.

  • 9 Joe Nobody // Jan 15, 2009 at 11:53 pm

    To EconStudent and the others.

    Thanks for the kind comments. Interesting info you posted too.

    The books/Publications I found interesting :

    I have a subscription to Money sense Magazine, it’s easy to read and they cover a wide variety of topics.

    The warren buffet way
    The lies about money
    How to pay less and keep more for yourself. Rob Carrick- who seems to get a lot of bad comments on the internet. But I liked his book very much. One of my favorites. Agrees about the poor returns of many mutual funds and the crazy fees. Backs it up with numbers. I like his approach.
    Lazy persons guide to investing (book about many different strategy’s) – first book i read about couch potato portfolio’s.
    The Lazy investor
    Live for today plan for tomorrow. Written by a local person not far from where i live. Approaches investing combined with life decisions. Very different read.
    Start late finish rich
    100 best stocks you can buy in 2009
    Plus a lot of sit down time at Chapters, just going through anything interesting. I read most of a recent book i think it was called “Enough” by the founder of Vanguard Funds there. A very interesting read.

    The Investopedia.com website with a cool stock simulator is quite informative as well.

    I would like to find a free & simple Mutual/Index fund Simulator website if there is one out there I would appreciate someone sending me a link.

    One other source depending on your view of use of the internet is like music and movies if you look around you can download a multitude of e-books and magazines from the internet from bit torrent sites. I know I’m a pirate I’m bad! Sorry! You will be very surprised to see what is there particularly at Demonoid.

    I read just about anything related to business, including the newspaper business section every day i can and Google Finance news and tools.

    Oh yes I just purchased a copy of the investors “bible” – The intelligent investor. That’s my next read. the new edition i got has comments on each chapter to help explain them.

    This is a really nice site too – I found it by accident.

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