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

Revised November 06, 2022

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." --- Earl Adamy

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 Modern Portfolio Theory 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.

Lost Time

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 four Bear Markets with declines of 44.7% (2000-2002), 55.2% (2007-2009), 35.4% (2020), and 24% (2022 through September) 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. Or if both assets are declining, selling some of the slower declining asset to buy more of the faster declining asset. 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”.

Diversification Fails When Assets Are Correlated

Moreover, an indispensable proposition on which buy-and-hold portfolios depend has drifted sharply from its moorings. Diversification only reduces risk where there is a lack of correlation between the portfolio components. The very essence of Modern Portfolio Theory lies in the expectation that when some assets depreciate, other (uncorrelated) assets will appreciate. However, a decade plus of Fed 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).

2022 (to date) has seen a 25% decline in equities and 16% decline in investment grade bonds.

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(s).

Reduce Risk by Cutting It

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 (see What Is A Full Market Cycle and Why Should I Care?) 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 (see What Can I Take Out When I'm Retired?) 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.

Funds To Be Used In Comparing Strategies

The Vanguard Balanced Index Fund is the poster child for Strategic Asset Allocation. Vanguard Balanced 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.

While Open End mutual funds provide greater depth of history; we prefer to use Exchange Traded Funds (ETFs) wherever possible. We will use two Vanguard ETFs with infill from their similarly indexed OEFs for depth of history.

  • VTI (inception 2001) & VTSMX: the Vanguard Total Stock Market Index Fund includes US large, small, and mid cap stocks. Its holdings are nearly identical to those of the equity portion of the Vanguard Balanced Fund. Its OEF equivalent is VTSMX with history back to 1992.
  • BND (inception 2007)& VBMFX: the Vanguard Total Bond Market Index Fund, which includes US government  and corporate investment grade bonds.  Its holdings are nearly identical to those of the fixed income portion of the Vanguard Balanced Fund. Its OEF equivalent is VBMFX with history back to 1987.

A 60% allocation to VTI and 40% allocation to BND approximates the results of VBINX, the Vanguard Balanced Index Fund for which there is no comparable ETF.

Tactical Momentum And Strategic Asset Allocation Compared

Our comparison consists of three setups

  • Strategic Asset Allocation is represented by holding the Vanguard Balanced Index Fund
  • Tactical Asset Allocation is represented by two sets
    • Fund switching using a simple weighted 3/6/13/26 week Rate Of Change
    • Fund switching using TAAStrategies own Adaptive Dynamic Momentum

The Tactical Asset Allocation Model will employ two rules for Tactical Asset Allocation:

  • 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.

We run the Tactical Model through three full bull and bear market cycles (and one partial cycle) starting with January 2000. The chart shows that this very simple Tactical Asset Allocation strategy handily outperforms the Vanguard Balanced Index Fund.

Summary statistics for each set (22+ years: January 2000 through October 2022)

  • Vanguard Fund: Compound Annual Growth Rate@ 5.7% with 32.6% Maximum Monthly Drawdown
  • Tactical with ROC: Compound Annual Growth Rate@ 7.6% with 20.4% Maximum Monthly Drawdown
  • Tactical with ADM: Compound Annual Growth Rate @ 9.6% with 14.3% Maximum Monthly Drawdown

Note: Compared to the Vanguard Balanced Index Fund, the S&P 500 showed a slightly higher Compound Annual Growth Rate @ 5.9% accompanied by a much larger Maximum Monthly Drawdown of 50.8%

Once a drawdown has been incurred, the drawdown must be fully recovered before portfolio growth can resume. Big drawdowns require long recoveries. Much of the outperformance is attributable to drawdowns which are significantly lower than the Vanguard Balanced Index Fund. Not only are drawdowns reduced, but the total gain of the best tactical strategy is nearly triple that of the Vanguard Balanced Fund. (Remember to subtract the starting $100,000 when calculating the net change in value.)

While Vanguard Balanced held a constant equity/fixed income allocation for 20+ 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 20+ years, the Tactical Model did a far better job of adapting to market conditions. The average Tactical allocation was 70%+- equity and 30%+- fixed income.

The returns from both Tactical strategies were far superior with much lower drawdowns.

A Word On Taxes

Strategic Asset Allocation aka "buy and hold" is highly tax efficient for the simple reason that portfolio adjustments are semi-annual or annual which tends to reduce realized gains and losses. The challenge for most investors is that the "hold" part becomes a serious challenge in the face of periodic steep drawdowns. 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 factor 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 simple example above, that the better tactical strategy produces a return which is nearly triple that of the Vanguard Balanced Index Fund. (Our Adaptive Global Strategy handily outperforms both of the example strategies.)

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. The process is systematic, disciplined, and repeatable.

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.