Journal of Financial Planning: June 2013
To identify one of the latest “trends in investing,” simply look to a few industry studies and you’ll find an impressive adoption of tactical asset allocation strategies over the past few years. FPA’s Trends in Investing surveys (conducted from 2008 through 2012) reveal that the rise of tactical asset allocation has quietly but steadily been under way and in fact now constitutes the majority investing style. Although not all financial planners necessarily characterize themselves in this manner, the 2012 FPA study (the most recent one conducted) revealed that a shocking 57 percent of planners “recently (within the past six months) or are currently re-evaluating the asset allocation strategy [they] typically recommend/implement.” When asked what factors are being reevaluated to alter the asset allocation strategy, a whopping 81 percent of respondents reported they continually re-evaluate, and 72 percent re-evaluate because of anticipated or existing changes in the economy.
Meanwhile, the April 2013 issue of the Cerulli Edge–U.S. Asset Management Edition reports that nearly half of advisers incorporate some sort of tactical strategy into their client portfolios. Just three or four years ago, the numbers were barely single digits or didn’t even register on these kinds of studies. To gain some expert insight into this trend in investing, we turned to three leading thinkers on tactical asset allocation: Mebane Faber, CAIA, CMT; Jerry Miccolis, CFP®, CFA, FCAS; and Ken Solow, CFP®, CLU®, ChFC®.
Michael Kitces: We see this trend that adviser adoption of tactical asset allocation strategies is growing. But the tactical label seems to mean different things to different people. How do each of you define tactical asset allocation?
Ken Solow: I would say tactical asset allocation is changing the asset allocation of a portfolio to take advantage of value opportunities in the marketplace. Perhaps the confusion out in the marketplace is that there are any number of methods for buying and holding where the managers essentially are changing the allocations of their portfolios, but the adviser is buying and holding them in fixed percentages. That’s not what we mean by tactical. Tactical, to us, is where we, as the manager of the portfolio, are changing the allocation between asset classes.
Meb Faber: This is always a challenging question, because the way we look at the world is that everything is active. Even when you’re investing in a passive strategy, to us, that’s active if you are setting up buy rules, sell rules, rebalance rules—whatever that may be. Our approach is that we come up with a strategic allocation, which is broad targets for asset classes we would like in a portfolio. From there, we’re asset class agnostic. We don’t want to fall in love with any asset class. We realize some asset classes are great sometimes and horrific other times. We want to be able to build portfolios that can withstand any potential market environment, but most importantly, is [building] portfolios that people understand, are comfortable with, and fit their beliefs, psychology, and risk and return objectives.
Jerry Miccolis: It’s hard to define “tactical” without defining “strategic” at the same time, so let me define them both. Also, the distinction between them is going through a transition as we speak.
When we do strategic, we do that from the ground up, meaning we’ve developed capital market assumptions, asset class assumptions, and then we do an optimization and come up with a set of strategic asset allocations. We do that exercise every 12 to 18 months, even though we expect a strategic allocation to stand the test of time and last much longer. We also review our underlying assumptions every year or so. Sometimes that results in a change in strategic allocations and sometimes it doesn’t.
Anything we do to change allocations in between those ground-up exercises we consider tactical, and those [changes] in the past have included things like shortening up fixed-income durations, moving out of Treasuries, and moving from developed countries to emerging markets. And sometimes we do it to take advantage of new investments that have come online, like catastrophe bonds.
Going forward, we’re looking to obliterate the distinction between strategic and tactical because even the strategic allocations depend on certain underlying assumptions about the economy and the capital markets, and those assumptions are dynamic and they change. And your assumptions that feed into your strategic allocations need to change along with them.
Over time, this will become kind of seamless. You’re constantly looking at the economy, looking at the capital markets. At some point, the changes you see are going to become material, requiring changes in your underlying assumptions. Those assumptions then get fed into your exercise that results in new allocations. At that point, the distinction between strategic and tactical gets pretty fuzzy. We’ve come up with another label for it, and that’s “dynamic asset allocation.”
Kitces: Is being tactical an alternative to modern portfolio theory (MPT) or just a different way of applying modern portfolio theory?
Solow: I think Jerry kind of hit it when he talked about using the optimizer. You can optimize a portfolio and if you optimize it once a week, you’re going to get changing asset allocations [as market conditions change], and from the standpoint of what’s happening in the portfolio, you’re going to get something that looks tactical. It’s all going to be based on the assumptions you’re feeding into your model.
Conversely, the way modern portfolio theory has actually been practiced for many years by advisers is something totally different than that. Advisers have used historical data to feed into those models. And the perception is that risk is being managed because of these historical relationships between standard deviations, correlations, and past returns.
The other thing is modern portfolio theory is built on an efficient markets hypothesis model. It’s really the opposite of what we’re using as a basic philosophy for changing the asset allocation. We’re trying to find good value. Modern portfolio theory is assuming that—at least classically— those markets are efficient, even though they’re changing. So as Jerry said, you could obliterate the differences just by running the thing all the time. You’re going to end up with changing asset allocations. If you chose to change based on that particular set of criteria, that would be fine with me and I would call it tactical. But as a practical reality, I don’t think that’s how MPT is used by 99 percent of the people who use it.
Faber: We’re okay with the basics of modern portfolio theory—trying to find a really globally diversified portfolio of various assets. Moving people away from a traditional 60/40 [allocation] I think is a good thing.
The difficulty is there are often different market regimes, and assets behave very differently in those types of regimes, where there’s rising inflation or falling inflation and low and high types of growth.
But we do tend to be okay with buy-and-hold types of modern portfolio theory results. The biggest challenge is many people need to be able to withstand the drawdowns of those portfolios, and they’re typically not prepared for how big those drawdowns can be, having either not looked back far enough historically or not really testing their allocation in enough environments. So some of the takeaways from modern portfolio theory I think are okay, and others, I think, are really, really dangerous.
Kitces: Many tactical strategies seem to be based on models built around historical models. How do we know that applying this kind of process is going to work going forward?
Miccolis: This relates to the problems with how modern portfolio theory is used. In our view, modern portfolio theory is just taking what we call the three Rs for each asset class—returns, risk, and relationships with other asset classes—and figuring out what the best mix of those asset classes are to get the best-performing portfolio in some sort of risk-adjusted sense.
Of the three Rs, probably the most important is the return assumption, and that’s got to be forward-looking. The problem with looking at history is you’ve got a bunch of regimes mixed together, so the first step is to parse history into different regimes. That can lead you to know what regime you’re in now, and then to just use that subset of history that is representative of that regime.
Faber: Looking at historical data is really important. One of the reasons a lot of people in ’08 got into trouble is that they didn’t look at enough market regimes or environments. They weren’t necessarily saying, “What has Japan looked like for the past 20 years?” or “What happened to the U.S. in the 1930s?” If you get an appreciation for enough environments, you start to realize there are a lot of possible outcomes, along with the knowledge that the largest drawdown in any asset class is always in the future.
So we appreciate history but also realize, of course, that environments can be different going forward. You have to be able to take a step back and say, “What is making sense here?” as opposed to simply, “What does the model say?” So it’s a combination of looking at history but also keeping your wits about you.
Solow: I think using the word “certainty,” as in “advisers are looking for certainty” about any strategy is a misplaced term. I mean, we’re in the business of managing risk. We’re looking at probabilities. Part of the confusion here is when there’s a misuse of average returns in more traditional methods of strategic asset allocation. People confuse taking long-term averages that are developed over many different regimes as adding some type of certainty to forward-looking returns. As long as you go out long enough, somehow that adds to certainty, and that’s just false. The reality is that I don’t think either strategy—strategic or tactical—gives you certainty.
One of the issues we see with tactical strategies, though, has to do with time. Many tactical strategies are employed over very short-term timeframes, and to the extent that you shorten the timeframe, I think you add to the uncertainty of what kind of results you’re going to get.
So that’s the beauty of strategic asset allocation—it’s employed over very, very long periods of time. And of course it requires investors to be very, very patient, which is why I guess many advisers are moving toward tactical.
Kitces: Should we be worried that this whole thing may be a fad or short-term opportunity and that when enough people do it, it will just be arbitraged out of the market?
Solow: If everybody was employing the same definitions of value, then I would think there would be opportunities for arbitrage. But contrarian investors are going the opposite of the herd, so I’m not quite sure how you arbitrage away contrarians who are trying to do the opposite of what the rest of the market is doing.
For me, the notion of buying something with good value, however you define it, I don’t think that can be a fad. That’s the basic fundamental that builds longer-term return. Here at Pinnacle, we define [good value] several different ways; we do it technically, we do it based on fundamentals, we do it quantitatively.
So no, I don’t think tactical, if it’s built around any of those types of things, would be a fad. I think it’s what should be the bedrock of any portfolio construction.
Miccolis: There are a number of reasons why it might not be smart for an adviser to do tactical asset allocation. They may not be qualified, they may not have a solid conceptual framework within which to do it, they may just be guessing, they may be putting their clients at more risk than if they didn’t do it. There are a lot of sound reasons why they should think twice before doing it, but the fear that it might someday be arbitraged away I don’t think ought to be one of them.
Kitces: All of you run some sort of tactical funds or tactical strategies for clients or even for other advisers, but is it feasible for advisers to implement tactical strategies on their own?
Faber: Of course! There are many types of tactical adjustments an adviser can make that would be reasonable to make on their own. The question could even be framed as, is it reasonable for an adviser to run a strategic portfolio on their own? And the answer is yes, as long as they have it set up the way that they believe and stick to it with a reasonable focus.
In many tactical portfolios, the biggest difficulty is not actually the construction of it or the actual theory. There are plenty of them that have been shown to work and are very simple. But one of the biggest challenges is sticking with your guns and not letting your emotions guide you to the market fads and the psychology of pain of loss. But that’s the same with any investment approach.
Solow: Some of the basics you need if you’re going to do this is—at least from Pinnacle’s perspective—is you need some independent research, which is a budget item. For us, you need full-time analysts doing this. I don’t know that you could be doing client service and be an expert in financial planning at the same time that you’re an expert in the markets. So you probably need one or more analysts. We have five of them here.
I think you need to create some type of model-based approach. It’s very difficult, I think, to be tactical and active and come up with 750 custom portfolios. There are some tools out there, but I think it’s best to create some models and focus your team’s attention on the performance of those models.
You need the trading technology. You need some kind of platform that’s going to allow you to execute trades, because there are typically a lot more transactions than if you’re just strategically balancing once a quarter.
Miccolis: I would just add one thing—you don’t want to do it based on guesswork. You’ve got to have some sound, conceptual framework to base it on, and you better test it. Before we introduced our own tactical approach to large-cap equity, we tested it for a year.
Kitces: For advisers who are just getting started with tactical strategies, or are just looking into them, what should they do first?
Solow: A good place to start is: Are you going to be quantitative or qualitative in terms of your decision making? Are you going to do this based on some type of rules-based approach to decision making? Are you going to do it much more subjectively?
At Pinnacle, we’re fairly distrustful of both methods, so we incorporate both. And as Jerry and Meb said, I also think coming up with some type of a repeatable process, something that’s systematic in how you approach this, is critically important. It gets to what Meb said about how are you going to be consistent in down markets or up markets where emotions get in the way. You need to have that repeatable process.
Faber: Many people just starting out think they have their investment approach from day one. They say, “Look, I’m a value guy,” “I’m Warren Buffett style,” or “Hey, this is my tactical approach.” And you know, for many people it takes years, and then it’s years of refinement on top of that.
So if you’re just starting out, you’re going to have to spend years probably doing research and reading to find what you know and what you don’t know. Even then, the easiest way may be to find an organization that you share some interest or values with that you can learn from and get a mentor. The toughest way is doing it on your own.
But no matter what, it’s critical to find an approach that resonates with you as an individual or a team or a company—an approach you can be happy with. It doesn’t have to be complicated. An approach that is comfortable is certainly something that can be done at any age and any level of complexity.
Kitces: How do you evaluate the success of a tactical strategy or a tactical manager?
Miccolis: Presumably, before you start down the tactical path, there’s some objective you have, and that is either to outperform some bogey or to have equivalent return with less risk, or some combination. Whatever your objective is, you’ve got to rigorously hold up your results against that objective and see if you did what you set out to do.
Any outperformance would have to be sustainable on some sort of risk-adjusted basis. And by sustainable, I mean over several market cycles.
Faber: I think there are typically two types of active managers in a traditional sense. There are those seen as more on the subjective side. They may have a process, but in general, you’re investing in them in the hopes that they can generate alpha. And depending on what asset class or world they’re targeting, the benchmarks can be very different. It could be S&P 500, it could be Libor.
And then on the opposite side is a process-driven manager who may have a quantitative system or an index that invests in these types of strategies. And on that side of the ledger, they typically have a very clear benchmark.
The most challenging part about evaluating a lot of these strategies is it can be years of over- and under-performance, and by far the No. 1 hurdle—and of course, opportunity—in our profession is that people chase returns and chase asset classes and invest when a certain asset class or manager has done well, and then do the opposite on the downside.
So yes, [evaluating the success of a tactical manager] is a challenge. If you’re going to go with one, your timeframe should probably be at least a minimum of three to five years.
Solow: I think finding an appropriate benchmark is an ongoing mystery. It’s very difficult, and I think any evaluation of trying to find alpha is just a statement, in many cases, of what benchmark you choose.
I was looking just yesterday at the relative returns for the last two years of the S&P 500 versus small caps, international developed, international emerging, and commodities. U.S. equities have so hugely outperformed, that [against] any benchmark that has an overweight to U.S. equities, you’re going to find it really hard to generate alpha if you’re running a globally diversified portfolio. Now that doesn’t mean you can’t, but if you’re running a diversified portfolio with those differences in asset classes, it becomes tough.
So it makes it hard for a consumer when your notion of “are you being successful with a tactical strategy” is so tied to benchmarks. And there are active-market-based benchmarks. In other words—how am I doing versus the universe of other actively managed funds or hedge funds? That’s a very attractive benchmark, by the way, for most active managers right now since many have just been destroyed in this last bull market over the last four years, but may still look good against each other.
Or then you have asset class-based benchmarks—they’re not market-based universes of portfolios, but just constructed from asset classes. Both have their benefits and drawbacks. Of course, in our industry, there are also financial planning-based benchmarks.
I have found that consumers are becoming much more focused on relative performance. They’re demanding performance. I think that’s a function of two huge bear markets since 2000. And so there you go. That’s part of our job.
Kitces: How do you communicate a tactical approach to clients? What are the expectations you set, and how do you manage them?
Solow: Lately, our big challenge is managing the time horizon that clients are looking at [for] performance. And I find it very ironic, because back in the day when we were strategic, we used to tell clients, “We’ll look at returns every 20 years or so. Put your statements in the bottom drawer, and if you look sooner than that, you’re an unprofessional client.”
Now we’ve reached this place where we’re back to trying to educate our clients that the tactical strategies we’re using are meant to outperform over complete market cycles. So we’re breaking performance down into the individual components. For us, that’s the bull market of ’02 to ’07, the bear market from ’07 to ’09, and then the bull market from ’09 to present.
We’re trying to get them to think longer-term, and managing those expectations has turned out to be moving up to the top of our list. If we give them shorter-term performance, relative [to] performance information, then they tend to be looking at it monthly or quarterly, and it’s very difficult to execute our strategies over those types of timeframes.
Faber: You try to educate clients ahead of time on whatever strategy you have. You try to have your clients at least become comfortable; they know what it is you’re doing and what could happen and what to expect, but that doesn’t mean that their world is not impacted by [economic events] regardless of what you’re doing.
We’ve learned on both the public and private sides—the public side even more so—that the performance game is both a benefit and drawback. Money, regardless, washes in when times are good and washes out on the flipside as well.
Miccolis: The way we attempted to set expectations with our clients when we got more [actively] tactical was to be very clear that the reason we were doing it was for risk management purposes, not to generate alpha. What we were trying to do was protect them in a more proactive way. If the markets are going up, we’re happy to simply participate.
So we were very clear at the outset that that was our objective. We remind them at every opportunity that that’s what we’re trying to do—simply a better job protecting them from the downside, and whether it’s a sustained downside through a bear market or a sudden drop in a crash, that’s what our focus was. We were not trying to outperform markets that were doing just fine on their own.
Kitces: What are the risks to the client, and what are the risks to the adviser around following a more tactical process with investment management?
Miccolis: If you don’t deliver on your promises, the risk to you and the risk to your client are the same. In our situation, we positioned it as a risk management device, not an alpha generation device.
The risk we’re seeing is that if clients don’t participate in every last dollar of market appreciation, they tend to forget that this was done for risk management purposes. And in an environment where we haven’t had a bear market and we haven’t had a market crash, so in retrospect, risk management wasn’t needed, clients tend to get greedy. And the risk is that you may disappoint them.
Solow: I think the very definition of risk is changing as advisers get more into active management. It used to be that risk was defined relatively. All risk was relative to the markets that you owned. Using modern portfolio theory, you owned 10 asset classes. Your managers outperformed or underperformed relative to the underlying benchmark asset classes. And that was risk.
I think for many of our clients, they learned that risk is a more absolute concept of, “I lost money.” And so I think the risks to a client of being tactical in a practical sense would be more missing bull markets than bear markets. What I’ve seen over the last decade is most of the managers don’t have any problems going to fixed income or some other risk alternatives other than equities, maybe even making big bets going out of the market.
So the definition of risk is changing, I think, and how we deal with absolute numbers versus relative numbers is going to change as well, both in our reporting and how we manage expectations.
Kitces: What recommended reading or resources, or suggested first steps do you have for advisers who are looking at implementing tactical strategies?
Solow: I wrote a book called Buy and Hold Is Dead (Again), and it was originally intended for advisers, and then in the writing, they asked that I broaden out some of the themes, but the first half of the book tackles the theoretical reasons that tactical might make sense and some of the problems with modern portfolio theory. The second half of the book really digs into the practical aspects of how you might want to be tactical and what that involves, from research all the way through bottom-up security analysis, top-down macro analysis. As a primer, I would certainly recommend that book. I think it would help people get a good framework for what we’re trying to do.
So just doing the work, just doing the reading is probably going to move you past theory, and you’ll start to look at the world a little differently in terms of seeing opportunities where you weren’t even looking before.
And I would say for advisers who are looking to put a toe in the water and may not know where to start or you [want to avoid] the expense of putting together a tactical shop, there are several outsourcing types of alternatives out there.
Faber: There’s a lot of homework that needs to be done. There are a number of different programs depending on your focus. Certainly the CFA or CMT [Chartered Financial Analyst, www.cfainstitute.org; Chartered Market Technician, www.mta.org], depending on fundamentals or technical analysis, or even the CAIA [Chartered Alternative Investment Analyst, www.caia.org] focusing on alternative investments. I think they’re all great curriculums; many are multi-year designations.
You could certainly read many of the books on your own as well. We have a lot of reading lists on our blog [www.mebanefaber.com] that detail other blogs and resources. I think it’s an ongoing process. It’s something that, for many people new to the world of active management, is probably a multi-year process, and even a lifetime after that to stay current.
There are a lot of resources on the web. One site I did that’s kind of fun is called The Idea Farm [www.theideafarm.com] where there’s a lot to learn from other people.
There’s a great quote from Charlie Munger: “I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting there and trying to dream it up all by yourself. Nobody’s that smart.” And that’s coming from one of the best capital allocators the world’s ever seen. So we’re big fans of reading other people’s work, and hedge fund letters, and other types of investment commentary, too.
Miccolis: I have five references for recommended readings. One is Ken’s book [Buy and Hold is Dead (Again)]. Second is any article Meb has ever written. I can’t profess to have read all of them, but I’ve read enough to know they’re very worthwhile. Third is my own book, Asset Allocation for Dummies. Fourth is a book that gets back to this idea of the seamless continuum between strategic and tactical called Dynamic Asset Allocation by Jim Picerno. And fifth is an article on dynamic asset allocation that my colleague Marina Goodman and I wrote for the Journal of Financial Planning [“Dynamic Asset Allocation: Using Momentum to Enhance Traditional Asset Allocation and Rebalancing Strategies” (February 2012)].
Michael E. Kitces, CFP®, CLU®, ChFC®, RHU, REBC, is a partner and the director of research for Pinnacle Advisory Group, a private wealth management firm in Columbia, Maryland. He is the publisher of the e-newsletter The Kitces Report and the financial planning industry blog Nerd’s Eye View through his website www.Kitces.com. He is a 2010 recipient of FPA’s Heart of Financial Planning award for his dedication to advancing the financial planning profession, and he also serves as practitioner editor of the Journal of Financial Planning. Follow him on Twitter at @MichaelKitces.