At our research blog GestaltU.com, we recently posted an article discussing how many noteworthy investment commentators either misunderstand or misconstrue the salient qualities of Tactical Asset Allocation strategies. In particular, we hope to clarify that:
- TAA does not require discretionary market calls;
- TAA should not be about market timing; and,
- It’s neither appropriate nor helpful to benchmark Global TAA (GTAA) funds against narrow domestic benchmarks
In Part 1 of this series we explored why quality TAA strategies do not rely on ‘expert’ market calls, noting that the terms ‘discretionary’ and ‘tactical’ ought not to be viewed as two sides of the same coin. Rather, the best tactical managers increasingly use systematic approaches to harvest persistent risk premia from factors such as ‘value’ and ‘momentum.’ This article will show why investors should not equate TAA with market timing.
First, let me be clear: tactical asset allocation is an active strategy. It involves regular shifts in portfolio composition – asset allocation – in response to changes in expected asset class returns, risks, and correlations, usually on an intermediate horizon. Some strategies are ‘binary’ in nature: a strategy will shift from 100% invested in a risky asset, such as a stock market ETF, to 100% invested in a ‘cash-like’ asset, like t-bills or Treasuries. These strategies are clearly ‘market timing’, as the goal is to be fully invested when market expectations are positive, and on the sidelines when expectations are negative.
However, market-timing strategies represent a very small sub-category within the broader TAA space. Most TAA strategies (such as Global Tactical Asset Allocation or GTAA) employ their methodology by choosing the best mix from a much broader and more diverse set of asset classes, with few ‘on-or-off’ type decisions. And there is a very powerful reason for this: market timing between two or three assets is much harder than choosing the best mix of a larger group of assets – in fact, there is reason to believe it’s more than 3x as hard!
A few years ago Que Nguyen (now Director of Portfolio Strategy and Analytics at Willett Advisors, NY Mayor Michael Bloomberg’s personal investment firm) studied the expected performance from market timing between stocks and bonds (or cash) versus selecting a mix from 28 global asset classes (18 stock markets and 10 bond markets). In essence, she simulated the performance of 75 different managers, each of whom selected assets once a month at random from his eligible universe over the period 1985 – 2003, with 55% accuracy. Chart 2 from her findings, copied below, describes the results of her experiment.
Note that when the performance of market timing managers and GTAA managers was standardized for active risk, the GTAA managers delivered 4x the alpha and 4x the Information Ratio (it’s easiest to think of the Information Ratio like you would a Sharpe ratio, but where the returns are adjusted for active risk rather than standard deviation). In addition, the likelihood of achieving positive alpha was 90% for the GTAA strategies, vs. just 63% for the market timers.
The point is, a small number of TAA strategies are truly market timers who are trying to call stock market tops and bottoms, but these types of strategies are rare. Furthermore, given how hard it is to succeed as a market timer, we would expect the proportion of market timing strategies within the TAA category to decline substantially over time.
However, the vast majority of TAA strategies do not fall into the market timing camp. Rather, the best TAA strategies harness value and/or momentum effects across a much more diverse global asset universe. And since the probability of achieving strong performance is a function of the breadth and diversity of one’s investment universe, we expect these more diverse Global TAA strategies to produce the best results going forward.