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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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Municipal Bond Investments and Marginal Income Tax Rates

Some investors hold municipal bonds in an attempt to reduce their tax burden. This article discusses the relationships between tax-exempt municipal bonds, marginal tax rates, and investment asset tax location.

An investor’s marginal tax rate is important, when making tax-related investment portfolio decisions. By combining your federal, state, and local marginal income tax rates, you can value the “tax shield” that you obtain from an incremental dollar of non-taxable bond investment income versus and incremental dollar of taxable bond income. The higher the combined marginal income tax rate, the higher the potential benefit from investments that yield non-taxable income.

Using 2008 tax rates, here are two examples with married couples filing joint tax returns who are California residents:

Example A — “Couple A” has $100,000 in taxable income after deductions and exemptions, which would put them into the 25% federal marginal income tax bracket and into the 9.55% state marginal income tax bracket, for a combined marginal income tax rate of 34.55%.

Example A — “Couple B” has $250,000 in taxable income after deductions and exemptions, which would put them into the 33% federal marginal income tax bracket and into the 10.55% state marginal income tax bracket, for a combined marginal income tax rate of 43.55%.

For an extra dollar of taxable income, Couple A would pay 34.55 cents in state and federal income taxes, while Couple B would pay 43.55 cents.

Both could avoid these taxes on an extra dollar of income, if they held a tax-exempt bond investment that was not taxed at both the federal and state income tax levels. California municipal bonds could shield them from these taxes and provide such savings. However, the question is whether the tax savings would be sufficient for one or both of these couples to warrant choosing tax exempt municipal bonds versus an alternative investment in taxable government or corporate fixed income bonds.

Because of investor bidding in real-time credit markets, the markets set differential investment yields on taxable versus tax-exempt assets.

The spread between these yields is influenced by bond investor supply and demand on an after-tax basis. Investors in higher marginal tax brackets have a greater incentive to own tax-exempt bonds. Those who benefit the most from tax avoidance tend to gravitate toward tax-exempt bonds and the opposite is true for those who do not.

To compare after-tax yields on taxable and tax-exempt investments, multiply the percentage yield on the taxable bond by one minus the marginal tax rate expressed as a decimal. Then, compare this result with the market yield on the tax-exempt bond. (Obviously, this comparison presumes that otherwise these taxable and tax-exempt bonds have similar maturities, likelihoods of default, and other provisions and characteristics.)

Assuming a taxable bond yield of 7%, Couple A with the combined marginal tax rate of 34.55%, would require that an equivalent tax-exempt bond would yield at least 4.5815% for the tax-exempt bond to be more desirable on an after-tax basis. [(7.0% times (1.0 minus .3455) = 4.5815%)]

Assuming a taxable bond yield of 7%, Couple B with the combined marginal tax rate of 42.3%, would require that an equivalent tax-exempt bond would yield at least 3.9515% for the tax-exempt bond to be more desirable on an after-tax basis. [(7.0% times (1.0 minus .4355) = 3.9515%)]

Clearly, the investor with the highest combined marginal tax rate has a stronger preference for holding tax-exempt municipal bonds. Investors in the highest total federal and state marginal income tax rate brackets get the most benefit, because the after-tax value to them could exceed significantly the actual market yield spread between taxable and tax-exempt bonds.

The lower one’s marginal income tax rates, then the lower ones potential tax shield benefit. At some point, municipal bond yields become disadvantageous for those who have lower marginal income tax rates, when compared to owning taxable fixed income investments. Whether or not to invest in a municipal bond versus taxable bond, of course, depends upon a variety of factors. These include one’s marginal tax rate, the spread at the time, the tax status of the account holding the asset, the concern for potential default, the duration, etc.

This analysis also demonstrates why municipal bonds should never be held in a tax-advantaged retirement account.

With a tax-advantaged retirement account, the current marginal tax rate on both taxable and tax-exempt bonds would be zero. Tax driven bond market supply and demand forces taxable yields upward or tax-exempt yields downward – whichever might be your perspective. Therefore, only taxable bonds should be held in tax-advantaged retirement accounts because of taxable bond yields would tend to be higher than tax-exempt yields on otherwise equivalent bonds.

There is a “sweet spot” for certain investors to hold municipal bonds

Given the factors discussed here regarding marginal income tax rates, bond market taxable versus tax-exempt yield spreads, and the optimal asset location decision between taxable and tax-advantaged accounts, there is a “sweet spot” for certain investors to hold municipal bonds. Those who are more likely to benefit from municipal bonds have the following characteristics.

These investors tend to have an asset allocation that more heavily skewed toward bonds, and they tend to have far more assets in taxable rather than tax-advantaged accounts. Furthermore, they have relatively high current earned income. Investors with this profile, “fill up” their tax-advantaged accounts with taxable bonds. Next, their heavy allocation to fixed income assets then “spills over” into their taxable accounts. In this circumstance, their very high marginal income tax rates might make owning tax-exempt municipal bonds a more advantageous proposition. Nevertheless, an analysis should always be performed using current bond market yields and total marginal tax rates to confirm that tax-exempt municipal bond investments would be more advantageous.