Some investors advocate tactical asset allocation (TAA) or the practice of adjusting the portfolio mix of stocks, bonds and cash to economic and/or market conditions. In his book Contrarian Investment Strategies, David Dreman notes that while it’s true that an investor who could successfully TAA could grow money on trees, TAA is difficult to practice because “real market movements give dozens of signals, madly flashing buy, sell and hold all at once”. Mr. Dreman then compares the performance of mutual funds that employ TAA to their benchmark and finds the results disappointing.

Does it work? The figures are not encouraging. Figure 3-1, taken from Lipper and Morningstar data, shows the returns of 186 asset allocators for the 12 years to September 1997 compared to the S&P 500 and the average of all domestic equity funds. The period covers a good part of the bull market, as well as the 1987 crash, and the sharp downturn in 1990. This was the ideal time for market timers or asset allocators to prove their mettle. They should have got you out before the 1987 and 1990 debacles and back in on time to ride the resurgent bull. Had they succeeded, you would have outperformed the market handily.

As the chart shows, heroes they ain’t. While the market surged 734% over the entire period, and the average equity fund moved by 589%, the asset allocators increased only 384%, about half the gain of the averages (all figures are dividend adjusted). Tactical asset allocation has obviously not set the world on fire. In fact, it’s downright awful, even in the periods where asset allocators claimed they swept the field.

The prosecution rests.

This article has 10 comments

  1. The rebuttal will take some time to prepare.

  2. Go Sampson! :)

    Interesting study. Again it doesn’t prove that successful tactical asset allocation is impossible – just fairly unlikely.

  3. Actually, I commented on Balance Junkie’s rebuttal. I don’t see it on her site, perhaps it is held for moderation. Anyway, the problem I still have is with the following claim:

    “While there is ample historical data to support the type of ultra-long term returns Potatoes hope to garner, there is also plenty of data to show that taking valuations into consideration can help boost those returns further. Standing aside (even if only partially) when markets are overvalued is another approach that makes sense”.

    I don’t deny that changing asset allocations can provide excess returns. Of course, one can earn spectacular returns by, on average, avoiding days like today and, on average, participating in the upside. My question is where is the evidence that investors employing this strategy on average are able to “boost returns further”? Or evidence that investors can ex ante pick the winners among TAA practitioners. However, like Dreman points out there is reams of evidence against market timing and TAA.

  4. I am starting to think that the evidence is subtle and not captured by most academics who more often than not have a focus too centered either within the US market, or the market in the country in which they reside.

    I know TTA is a loaded term, and hence pushes people to extreme opinions. However, it is starting to become clear to me that home country bias demonstrates that some form of TAA can produce greater returns. Think of our home bias, vs. Japan. We have all been fortunate because home bias is hard to shake and somewhat inherent in the way we, as Canadians invest. If we were Japanese, things probably wouldn’t be as rosy. Look at a 10 yr chart among XIU and IVV…

    I will concede that it may be difficult or even impossible (maybe) to predict ahead of time where the out performance may lie, but the difference in returns are not subtle.

    I task it to myself and you all, (we’re smart enough), there is/must be some way to draw some ‘tactical’ conclusions, at least over the short term of how to outperform the basic passive portfolio, after all, when was the last time any of us made a substantial investment in Japan?

    (I originally wanted to bring out some references, but soon realized it wasn’t necessary, it may be up to you to up the stakes – I even have a Fama and French reference from 3-4 years ago, but that’s an ace in the hole I’ll bring out later).

    Defence is not ready to rest yet, but almost.

  5. I meant to write,
    “look at a 10 yr chart among XIU, IVV, and EWJ”

  6. I would have a difficult time applying a tactical asset allocation strategy with my portfolio because there are so many uncertainties that present themselves in the markets to allow for me to forge ahead with confidence.

    There are ‘moments’ where I feel as though I have an educated inclination with respect to where I believe certain sectors are heading (ex. I am bullish on oil), but I’m not about to start directing large chunks of my portfolio value in that direction in order to try to reap the benefits with respect to where I believe things are heading.

    More often than not, I suppose it boils down to the individual investor’s risk tolerance and comfort zone in employing such a strategy.

    Nice post!

  7. I meant to add that I would also have a difficult time altering my asset allocation on a large scale despite major changes in the overall economy, markets, etc.

    For example, just because GIC rates are considerably low in recent months/years (you’d be lucky to fetch a 5-year paid monthly GIC at over 3.0% right now), I still require a minimum amount of safety in my portfolio. Despite the generally low amount of interest income being earned, I cannot justify redirecting more of my hard-earned dollars to higher yielding equity plays for the sole objective of taking advantage of events that may or may not prove to become a reality.

  8. @Sampson: “I will concede that it may be difficult or even impossible (maybe) to predict ahead of time where the out performance may lie, but the difference in returns are not subtle”.

    I don’t disagree at all that returns could be dramatically different across countries. In fact, that’s the rationale for global diversification. But moving in and out of markets (i.e. selling your stocks and moving to cash with the plan to move back into stocks in the future) is a recipe for making serious mistakes. If an investor wants to hold off on some new investments because an asset class is overvalued, that’s fine. It may or may not work out and if a mistake is made, the consequences are not serious.

    Here’s one example. In the past the dividend yields on stocks were typically higher than bonds, so a working strategy was to sell stocks whenever yields dropped below bonds and then buy them back again when yields were higher than bonds. It would have worked for decades until one time the yields dropped and stayed there for 40 more years. An investor investing according to this model would have either (a) sat out for the initial few years and then looked for a new model or (b) sat out of 40 years of stock market gains. That’s the trouble with models of the stock market. They may have worked in the past, they could continue to work but there are no guarantees.

    I do think there are other options if one is looking to improve on a plain vanilla couch potato. They can slice and dice their holdings for value and small cap. Unlike TAA, there is plenty of evidence across markets (but not in all time periods) that these factors increase returns or reduce risk or both. However, a slice and dice investor has to keep in mind that the strategy could lag in some markets. Unfortunately, I think it boils down to temperament. It’s really hard work to do nothing when your strategy appears to be temporarily not working. Nobody likes to see their brother-in-law make more money than themselves in the stock market. But trying to improve on a pretty good strategy could drive one batty.

  9. I think it depends on what you meant by TAA or market timing. If you mean sector rotation, seasonality, etc. I agree that this is very difficult. A relatively simple timing system using a longer term moving average does seem to work to at least reduce portfolio volatility and drawdowns if not increase returns. Mebane Faber has done some research on this that is worth reading. Having a plan to sell using an objective trigger is a better idea that having no plan and selling out of panic.

    Retail investors tended to severely underperform even professional managers in the last 15 or so years. I imagine this is mostly due to a lack of discipline. It is very hard for retail investors to sit on their hands as their equity investments fall by 50%, listening to the doom and gloom, and resist the urge to save what you have left.

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