What Is Tactical Asset Allocation? How Does It Improve Returns?

Tactical Asset Allocation is an active management strategy that dynamically adjusts a portfolio’s asset allocation to current market conditions with the objectives of minimizing the potential for large losses and maximizing opportunities to improve returns. Tactical Asset Allocation employs a mechanical approach to selection of funds within a basket of low cost index funds.

The allocation algorithm reduces exposure to weak funds and increases exposure to strong funds. Tactical Asset Allocation baskets include funds selected from among different asset classes (e.g. equities, fixed income, commodities) and sub-classes (e.g. domestic equity, international equity, emerging equity) of assets.    

"Perhaps the single biggest distinction between Tactical Asset Allocation and Modern Portfolio Theory is that while Modern Portfolio Theory seeks to reduce risk by spreading it across several asset classes, Tactical Asset Allocation seeks to reduce risk by cutting it."

Where there is Return, there is Risk

Investors want the highest returns but it has been obvious, from the earliest times, that the  projects with the highest returns, like sea voyages to far off lands, are also the most likely to fail, and so project risk must be taken into account. One way to ensure that sunken ships did not sink your business entirely was to bet on several captains, in other words, not put all your eggs in one basket: the intuition that diversification lowers risk is an old one.

However, despite the recognition that some investments were riskier than others, investment theory until the middle of the twentieth century focused on estimating returns. There was a puzzling neglect of risk; an implicit assumption that all investments were equally risky, a proposition that, like the emperor’s new clothes, should have been easy to see through.

Modern Portfolio Theory

In 1952, a young economist named Harry Markowitz published a paper titled “Portfolio Selection” which offered a mathematical exposition of why diversification lowered risk. This paper gave rise to what is now referred to as Modern Portfolio Theory, an approach to investing that has proved to be very influential since most portfolios, including mutual funds and pension plans, are managed using some variant of Modern Portfolio Theory. This approach assumes a long-term investment horizon, often 20 to 30 years. For this reason, portfolio selection under MPT is often referred to as “Strategic Asset Allocation“.

Strategic Asset Allocation

Strategic Asset Allocation is a passive “buy and hold” strategy. Portfolio construction starts by setting investment goals and ascertaining the investor’s risk tolerance. Then a diversified collection of assets are bundled to achieve the expected returns based upon the investor's risk tolerance. As Modern Portfolio Theory postulates, there is a relationship between risk and return. Higher expected returns are hardly ever possible without taking on more risk.

A typical Strategic Asset Allocation portfolio employs a buy-and-hold strategy constructed to include multiple asset classes with emphasis on equities and fixed income. A fixed target allocation for each asset class is then selected, e.g., 60% stocks and 40% bonds, referred to as a 60/40 portfolio. This allocation is maintained throughout all market conditions.

While the concepts embedded in  Modern Portfolio Theory are central to portfolio management, there are several major flaws inherent in the customary implementation.

While on the surface, it would appear that investors with twenty or thirty year horizons can ignore such volatility, their portfolios spend years recovering the losses before growth can resume.

First, the long term averages used in establishing target allocations hides market volatility. Consider, for example, that during the past twenty years, we have seen two Bear Markets with declines of 44.7% and 55.2% respectively. While on the surface, it would appear that investors with twenty or thirty year horizons can ignore such volatility, their portfolios spend years recovering the losses before growth can resume. Investors approaching or in retirement who depend upon their portfolios for some or all of their income do not have the luxury of twenty or thirty years to average the volatility and will find recovery challenging if not impossible.

Selling Winners and Buying Losers

The second major flaw is that the portfolio rebalancing process is inherently counter-productive. Portfolio rebalancing is performed annually or semi-annually to maintain allocation weights. Rebalancing is required because, as market prices fluctuate, the proportionate value of the assets composing the portfolio shift from their targeted percentages. For example, a rise in equities may result in a 60/40 portfolio becoming a 65/35 portfolio, requiring adjustment to restore the 60/40 allocation.

While a first appraisal of this approach often makes it seem a prudent strategy, a second look reveals something rather strange: it means selling off an asset class experiencing a rising trend and increasing the holdings of an asset class with relative falling value. Although, it’s great to buy when prices are low and sell when prices are high, those decisions should not be triggered by the desire to maintain portfolio composition. Applying such a strategy to maintain portfolio composition reduces the opportunity to benefit from assets that may be appreciating and increases the risk that the portfolio will invest in assets that are declining in value. As Warren Buffett says, “diversification is protection against ignorance. It makes little sense if you know what you are doing”.

Reduce Risk by Cutting It

Moreover, an indispensable proposition on which buy-and-hold portfolios depend appears to be drifting from its moorings. Diversification only reduces risk where there is a lack of correlation between the portfolio components. If some assets are likely to depreciate, then others will appreciate. However, present day monetary policies have caused riskier assets (equities, high yield bonds, emerging market instruments) to be priced much closer to less risky assets (CDs, investment grade bonds, and Treasuries).

Central Bank suppression of interest rates has significantly increased correlations across all asset classes. This means that asset class "diversification" has lost significant value as a risk management tool. Investors can reasonably expect concurrent declines in a broad swath of asset classes during the next Bear Market.

Cutting risk instead of diversifying it away adds a critical element to capital preservation. Perhaps the single biggest distinction between Tactical Asset Allocation and Modern Portfolio Theory is that while Modern Portfolio Theory seeks to reduce risk by spreading it across several asset classes, Tactical Asset Allocation seeks to reduce risk by cutting it.

Six Key Reasons To Cut Risk

Drawdowns are a critical piece of every Full Market Cycle and there are six key reasons why they matter:

  • Drawdowns must be fully recovered before the portfolio can return to growth.
  • Investors approaching, or in retirement, may not have the luxury of the years required to recover losses.
  • Drawdowns are a key measure of investment risk relative to the investor’s risk tolerance. Is your tolerance for portfolio loss before throwing in the towel: 10%? 20%? 30%? 40%? 50%?
  • If you sell out when the drawdown exceeds your tolerance level, how and when will you get back in?
  • Drawdowns are a key measure of the portfolio manager’s effectiveness in controlling risk.
  • Drawdowns play a key role in calculating what I refer to as the Sustainable Withdrawal Rate for a portfolio

Effective portfolio management must avoid large drawdowns. A portfolio that has suffered through a 55% Maximum Drawdown, as seen for the S&P 500 during the 2007-2009 Bear Market, must more than double in value to restore portfolio value. Further, you must have the time available to wait for the market to recover, which becomes particularly challenging if you are retired and making regular withdrawals.

The Simple Mechanics of Tactical Asset Allocation

Tactical Asset Allocation is a dynamic management strategy which begins with a basket of low-cost, passive index funds. The fund basket consists of a range of asset classes including equities, fixed income, and commodities as well as numerous sub-classes within each asset class.

Funds within the basket are ranked periodically from best to worst. Ranking frequency can be daily, weekly, twice monthly, or monthly. Ranking criteria always includes momentum and may be supplemented by other criteria including asset class, volatility, and risk.

Best ranked funds are selected to improve returns while worst ranked funds are discarded to reduce risk. 

Tactical Momentum And Strategic Asset Allocation Compared

It is quite simple to illustrate the differences. We begin with the Vanguard Balanced Index Fund (VBINX), the poster child for Strategic Asset Allocation which is widely considered a suitable core portfolio holding for all investors. Vanguard Balanced applies a fixed 60% allocation to equities and 40% allocation to fixed income.

Vanguard has two index funds which can be used to replicate the equity and fixed income allocations used in the Vanguard Balanced Index Fund:

  • VTSMX: the Vanguard Total Stock Market Index Fund includes US large, small, and mid cap stocks
  • VBMFX: the Vanguard’s Total Bond Market Index Fund, which includes US government  and corporate bonds

Rather than "buy and hold" the fixed 60/40 allocation, we are going to use our Tactical Asset Allocation Model to drive our investment strategy. There are two simple rules:

  • If one or both funds are rising, the entire portfolio is allocated to the better performing fund.
  • If both funds are declining, the entire portfolio goes to cash.

Adaptive Dynamic Momentum is used to measure relative momentum characteristics of the two funds. We run the Tactical Model through two full bull and bear market cycles starting with the Bull Market top in March of 2000. The chart shows that this very simple Tactical Asset Allocation strategy handily outperforms both the "The Market" and the Vanguard Balanced Index Fund.

Careful scrutiny of the chart shows much shallower drawdowns which are a little more than a third of the Vanguard Balanced and roughly a quarter of the Standard & Poor's 500. Not only are drawdowns reduced, but returns are more than double those of the Standard & Poor's 500 (remember to subtract the starting $100,000 from the ending value to calculate the net change increase in value).

Once a drawdown has been incurred, the drawdown must be fully recovered before portfolio growth can resume. Big drawdowns require long recoveries. The Tactical strategy's much shallower drawdown accounts for a good deal of the out-performance in Compound Annual Growth Rate.

While Vanguard Balanced held a constant equity/fixed income allocation for 17 years (60% equities and 40% fixed income), the Tactical strategy had a choice of being 100% equity, 100% fixed income or 100% cash during any one month. Over the course of 18 years, the Market Conditions Model did a far better job of adapting to market conditions even as the average equity/fixed income allocation very closely approximated 70%/30%.

A Word On Taxes

Strategic Asset Allocation aka "buy and hold" is highly tax efficient for the simple reason that portfolio adjustments are infrequent which minimizes realized gains and losses. The challenge for most investors is that the "hold" part becomes a serious challenge in the face of a Bear Market. It is common for investors to throw in the towel, partially or fully, in the face of large, and seemingly unending portfolio losses. Selling into a declining market to "stop the bleeding" is a sure fire way to turn unrealized gains into realized losses.

Because Tactical Asset Allocation makes more frequent portfolio adjustments, realized gains and losses are more frequent. This has no tax effect when used in tax-favored retirement plans; however it can be a disadvantage when used in a taxable account.

On balance, however, most taxable accounts will fare far better recognizing increased realized gains than recognizing losses. Consider, using the example above, that the Tactical Momentum Model produces a 55% higher Compound Annual Growth Rate compared to Vanguard Balanced.

Finally, well-designed Tactical Asset Allocation strategies can go a long way toward converting realized gains and losses to Long Term eligible Gains and Losses.

Conclusion

Tactical Asset Allocation combines the use of low-cost, passive index funds with an active management strategy to reduce losses and improve returns. There is a large body of academic research which is both substantive and compelling in making the case for the use of Tactical Asset Allocation to manage all or part of an investment portfolio. With both equity and fixed income markets at extreme levels of valuations; investors would do well to consider using Tactical Asset Allocation.

Read more Insights

What is Tactical Asset Allocation? How does it improve returns?

Adaptive Dynamic Momentun: A Major Advance In Tactical Asset Allocation

What is a Full Market Cycle and Why Should I Care?

What is a Market Conditions Model? How does it lower risk?

Tactical Asset Allocation Strategies, LLC is the developer of the TAAS Market Conditions Model and TAAS Global Adaptive Strategy which lowers risks and improves returns. The Strategy is available to self-directed investors by subscription.

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