Strategic Versus Tactical Asset Allocation

This article was originally published on ETFTrends.com.

By Rusty Vanneman, CFA, CMT, CLS Investments Chief Investment Officer

Investors often ask, and for good reason, which asset allocation approach is best: strategic or tactical. The answer, like much in the markets, is it depends. Investors should consider which matches up better with his or her philosophy, temperament, and objectives. These qualitative considerations are the keys to determining which approach is best suited to keeping investors participating in the market’s long-term growth.

Before I dive deeper, let’s define the terms. Different definitions are used by different market players, so it’s important to make sure everybody is on the same page before a proper discussion can begin.

At CLS Investments, we believe a strategic allocation approach is one that manages to a target allocation, whether one is targeting risk or an asset allocation. We target risk based on our Risk Budgeting Methodology. With a strategic approach, an investor should have confidence the portfolio will behave as expected and adhere fairly closely to the target. Strategic does not mean buy-and-hold or passive. It most often means active — in the sense that the portfolio is being actively managed to account for changes in expected risks and returns within the markets.

At CLS, we define a tactical approach as one where large and sudden changes in portfolio risk and asset allocation are made. While it may also have a benchmark to target over time, the portfolio could be vastly different from one period to the next. The great promise of tactical strategies, of course, is that they will lose less when the market is down.

Now that we have defined the terms, which approach is best, and when should each be used? The answer, of course, is it depends. It depends on who is using it and why.

It is my strong belief that strategic approaches are better in most cases, at least based on the numbers. They historically perform better, and are more efficient at generating risk-adjusted performance. At CLS, approximately 90% of the assets we manage are strategically managed and about 10% are tactically managed, so we might have a bias, but I believe the data that follows bears it out.

To compare performance, we reviewed mutual funds in the Morningstar database. While most tactical asset allocation (TAA) funds compete against the entire stock market, the comparisons below are against balanced mutual funds with similar risk and equity allocations. It’s a fairer representation, in my opinion.

Using Morningstar data through the end of 2017, and adjusting for portfolio risk, we compared (with the help of CLS analyst Mark Matthews) peer groups with similar risk to TAA funds. These include balanced funds, such as asset allocation funds (30-50% equity and 50-70% equity) and target-date funds (in this case, the 2020 vintage). We reviewed these balanced portfolios as they have fairly similar risk and asset allocations over time.

As the table below shows, the tactical asset allocation group’s average beta was 0.49 and its 3-year standard deviation was 7.11%. These numbers are similar, if not a bit higher than other balanced peer groups. Given the strong market returns over the last three years, this should give the TAA funds a performance advantage. Also, the average equity allocation of 54% favorably compares to two of the other three categories.

Despite the risk and allocation advantages mentioned above, TAA funds underperformed in terms of pre-tax performance. While TAA funds performed relatively well over the last year, they finished dead last in the 3-, 5- and 10-year time frames.

A significant reason for the underperformance, however, was cost. An expense ratio 50-300% higher and a turnover ratio 7x the average of the other peer groups provided a headwind for relative performance.

After-tax performance didn’t look good either. Over the last 10 years, the average TAA had an after-tax return of 2.36% — a last place finish, again, among the four other categories.

Perhaps most importantly are the pre-tax investor returns, which take into account shareholder flows in and out of funds in an attempt to capture the true investor experience. Again, not good.

To cut the numbers one more way and determine the difference between a fund’s return and an investor’s return — the “behavior gap” — we can see which funds have the most slippage in terms of investor behavior. The larger the number, the worse the gap.

It could be argued TAA funds would struggle for flows in any bull market, and I think that’s a fair point. But, the “U.S. Fund Allocation – 30% to 50% Equity” peer group is even more conservative, and that has held up better (though not over the last year). On a ratio basis — flows divided by assets under management (AUM) — the flows for TAA are strong, especially in the 3- and 5-year time frames. So, while the fees are higher for TAA funds, they don’t offset the fact that overall AUM is lower and much more volatile. In my experience, more service is required for TAA funds. More upfront education and more “hand-holding” via service and commentary are required, and there is still a higher shareholder turnover rate.

In addition, while strategic portfolios can represent an entire portfolio, TAA funds are generally not considered core holdings as they are better suited to be satellites or complements to core strategic holdings. When they are used as satellite positions, they often work best in combination with other TAA strategies. For example, a common amount that some investors, including CLS, use to allocate to tactical approaches is 30%.

So, why would an investor use a TAA fund when the numbers seem so against them? There are still a few good and valid reasons. First, investing is a very human enterprise, and emotions, such as fear, are often involved in decision-making. For many investors, a tactical approach is the only way they can get comfortable investing in the markets at all. The ultimate goal for investing is to at least “beat the bank” and not the market, so if using a tactical approach works for some investors, then it works.

There is another reason to use tactical approaches: sequence of returns. Stock markets don’t provide steady rates of return. Instead, returns are lumpy. Some years the market might be up big, other years it might be down big. Timing of the bad years can have a meaningful impact on some investors, particularly those nearing retirement and starting to draw income off the portfolios. A big loss in the year before retirement, for instance, can have a significant impact on a portfolio’s withdrawal rate and the portfolio’s chance of long-term survival. While an argument can be made for steadily reducing equity exposure in the years leading to retirement, it may also make sense to use a tactical approach in those years.

In general, I would argue for a strategic allocation approach. But, I fully recognize that adding a tactical approach might be required to keep many investors involved, invested (not sitting in cash), and participating in the economy’s and market’s long-term and resilient growth.

Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel. He can be reached at Rusty.Vanneman@CLSInvest.com.

Disclosure Information

This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.

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