Asset Allocation Strategy


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Post-financial crisis commentary on tactical versus strategic asset allocation

The best individual financial planning and investment rules and practices are enduring and should not change due to market cycles or a financial crisis. This article looks at asset allocation strategy in light of the recent credit crisis.

The credit crisis was a systemic, global financial event that impacted any financial or securities instrument influenced by debt and borrower credit worthiness. In short, the credit crisis affected everything. So many investors sought liquidity at the same time, because they either had to do so to meet their cash flow obligations and/or they feared greater losses and sought “safer” places for their money. Presto — the result was a global valuation downdraft that affected all asset classes. While some — but not all — classes of bonds did better relative to other asset classes, the real beneficiaries were those who already held bond positions before broader groups of investors got into a panic.

Whenever you are already there and invested in an asset class, it means that you probably were already following a passive asset allocation strategy. While tactical asset allocation strategy advocates will suggest that you can anticipate the crowd, this is not verified by studies of flows-of-funds into and out of investment mutual funds. While a very narrow segment of investors might have some skill in anticipating trends and does actively pre-position their investments relative to the movement of the crowds, most people already have their money invested in an asset class, because they have chosen strategically to be invested in that asset class for the long-term as a buy-and-hold investor. Flow-of-funds studies show that almost all tactical asset allocation fund flows are late money flows that chase performance after valuations have already moved. On average, this tactical asset allocation money is late money and these investors get inferior returns.

At the end of the first decade of the new millennium, huge cash flows into bond funds still continued relative to flows into other asset classes, such as stocks. This is a trend that was almost three years in the making. We have not seen similar disproportionate fund flows into bonds since the 1984 to 1987 period, when interest rates were much higher than today’s paltry yields. In succession during the past decade, we have experienced a technology bubble market crash, a housing bubble crash, a credit crunch, and a resulting global economic/business cycle crash. Barring a total global economic depression, which we seem to have skirted but avoided, what will happen to the bond markets when interest rates inevitably rise? Stay tuned for the next sector bubble crash.

Recently, there has been more advocacy of “tactical” asset allocation strategies by certain financial advisors. The logic goes as follows. Broad passively-managed asset class diversification strategies seemingly did not work during the credit crisis. Even broadly diversified investor portfolios went down, although not as much as portfolios that were more exposed to particular asset classes that had suffered the worst percentage declines. Therefore, buy-and-hold strategic asset allocation apparently did not work and should be thrown out. As a replacement, these financial advisors advocate that it is time to employ tactical asset allocation strategies that ‘could’ get better risk-adjusted portfolio returns in the future. You know, start moving things around to get ahead of the crowd and be there before the crowd arrives to drive up valuations.

Unfortunately, tactical asset allocation strategy advocates do not offer anything to back up their claims that tactical investment activity would actually be superior to a passive asset allocation strategy in the future. Tactical asset allocation strategies have not been superior in the past. Advocacy for tactical asset allocation strategies flies in the face of the broad body of investment research that consistently has shown that low-cost, broadly diversified, passive buy-and-hold asset allocation strategies tend to yield superior long-term risk-adjusted portfolio returns.

Broad portfolio diversification has never meant that a portfolio could not and would not experience short-term losses at the portfolio level. When you have an investment banking industry that finds clever ways to repackage smelly sub-prime mortgages as gilt-edged investment grade derivative mortgage securities and resells these stinkers in vast quantities to other “smart money” financial professionals across the banking and investment world, then we just might all have a problem. When doing this over and over gets a lot of clever investment banking types some very large bonuses, then there is a lot of motivation to keep that gravy train moving along.

While you might question the ethics of these clever investment bankers, you should not forget that they sold these toxic mortgage securities to other willing professional buyers in the global banking industry. Those professional banker purchasers, in turn, tucked these gilt-edged derivative securities into their banks’ capital asset portfolios — the very capital portfolios upon which the banks ran their leveraged loan operations. When the music stopped and all the emperors had no clothes, bank capital evaporated and so did their ability and willingness to make loans. Of course, this was all compounded by tens of trillions of dollars in CDOs (credit default swaps) that tried to pass the ultimate repayment responsibility for bad debt hot potatoes around. Did the investment bankers also make some sweet bonuses on the multi-trillion dollar CDO market? You betcha!

Without your taxpayer dollars via the TARP bank bailout, the US and the rest of the world would all be in the financial black hole of a long-term global financial depression. In that event, most people would not have had to worry about short-term paper losses on their investment portfolios. Instead, many would have liquidated their portfolio holdings at cents on the dollar to meet living expenses after their jobs vanished.

If you have been following the chatter, you might remember hearing that most TARP funds have been paid back and some TARP loans to the banking industry have been reasonably profitable. Of course, this supposed profitability is only positive from a very narrow perspective. Taypayers are not normally in the business of making bailout loans to the financial industry. While unfortunately necessary, it is difficult to argue that TARP loans were profitable to taxpayers, when you consider the vast global economic destruction that resulted; the job losses and the millions unemployed and under-employed; and the unreimbursed hole that many still have in their personal investment portfolios.

So, when a huge and systemic toxic asset problem exists in the financial system, and the credit house of cards begins to fall, why would or should a diversified strategic asset allocation strategy prevent a short-term loss at the portfolio level? And, why would tactical asset allocation be a superior replacement strategy? To the contrary, higher cost, less diversified, active investment strategies will do what they always do, which is lead on average to inferior risk-adusted returns at the porfolio level. Even in a dire financial crisis, you should not lose sight of the long-term and forget the lessons of financial history. Broadly diversified, passive, low-cost, buy-and-hold strategies have been superior in the past, and they are much more likely to beat tactical asset allocation strategies in the future.

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to “Asset Allocation Strategy”

John Schumacher Says:
November 29th at

While I agree that your numbers are probably correct regarding tactical asset allocation, that doesn’t necessarily mean it doesn’t work. The reason being is that most of the money being “tactically” transferred is due to greed (putting money in assets that have already increased in value) and panic (taking money out of assets that have decreased). By taking a contrarian approach to these emotions, I’ve found that you can increase your returns over straight buy-&-hold investors. Please note that I only move a small percentage of money between asset classes & keep each class within a desired percentage range. But even moving a small amount from an asset class that have gone up to one that has gone down has given me a good boost on returns.

John

Larry Says:
November 30th at

John, thank you for your comment.

A standard practice in financial planning is to establish long term percentage targets for the major asset classes and to establish a percentage policy tolerance. Simplistically, for example, with a 60% equities, 30% bonds, and 10% cash portfolio with 5 percentage point tolerance the bands, the ranges would be 55% to 65% equities, 25% to 35% bonds, and 5% to 15% cash. Given that the asset sizes are disproportionate, you could instead have per class tolerances or could apply the general policy tolerance as a percentage range for each asset class. In many senses, the choices are arbitrary. The point, however, is that once a portfolio strays close to or over the tolerance bounds, then one rebalances. This tends to be mildly contrarian in its operation and it is devoid of emotion. This is how a buy-and-hold investor maintains a relatively consistent over-all portfolio risk profile. Within this framework, which aligns with what you suggest, a passive investor can improve modestly upon their risk-adjusted returns — versus one who never rebalances and finds that their portfolio strays from a risk profile appropriate to that investor. However, the improvement may not be in absolute percentage returns, but in risk-adjusted returns that dampen portfolio value fluctuations.

Tactical asset allocation in the parlance of the industry and as discussed in this article is really a tactical strategy that shifts asset allocation percentages in anticipation of excess returns in various asset segments. Tactical asset allocation is a timing strategy that attempts to predict winners among asset classes. The preponderance of evidence is that this does not work, and particularly, it does not work, if you are paying someone a higher fee to do it for you. What has been most disturbing about this has been the increased chatter about tactical asset allocation among financial advisors, since the financial crisis began. These strategies increase portfolio risk without any evidence that financial advisors have any improved ability to peer into a completely opaque and unknowable future.

If tactical asset allocation did not work before the crisis, how is it a better idea now, especially if most of those advocating it did not properly anticipate the devastation of the financial crisis on their clients portfolios? Are these suddenly smarter after investment risk actually materialized and wacked everyone in the face? I doubt it. Advisors who did not anticipate the financial crisis and did not protect their clients — the vast majority of financial advisors — should not try to convince themselves and their clients that they can in the future.

Lastly, there is long-term evidence that a value investing approach is modestly superior to either a growth skewed strategy or owning the entire market basket. However, the issue here is not tactical asset allocation or moving among sectors within asset classes. Value investing depends upon metrics of asset value and a commitment to avoid “overpaying.” Value strategies are contrarian and they require skill and the fortitude to swim against the tide continuously. There are some investors with the skill, knowledge, and self-restraint to implement value strategies. They are few in number.

For the average investor who wants to live his or her real life without spending inordinate time on amateur investing, they need to farm out their investments to professionals. Lowest cost index mutual funds and ETFs are the way to go, and there are some lower cost value funds. However, these value funds are still more costly than the lowest cost broad market index funds, so the incremental cost needs to be weighed. My forthcoming book, “Lowest Cost Mutual Funds and ETFs” will address these subjects in much more detail. When it is out, you can find it in the sidebar.

 


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