Executive Summary
With the financial crisis of 2008-2009, some planners appear to be considering - if not adopting - a somewhat more active approach. Unfortunately, though, for many planners any investment strategy that is not purely passive and strategic must be equated to "market timing" - a pejorative term. Yet the planners who have implemented some form of tactical asset allocation generally do not call themselves market timers; they recoil at the term as much as passive, strategic investors do. So where do you draw the line... what IS the difference between being "tactical" and being a "market timer"? In truth, it seems that once you dig under the hood, the differences are nuanced, but they are many, and significant.
The inspiration for today's blog post stems from some ongoing discussions I've been having with several planners about what the difference is between "market timing" and "being tactical", and the implication from many planners that anything which involves making a forecast of the future and changing your portfolio - in ANY way - to be "evil market timing" that risks client destitution. After all, as they point out, at some point you have to execute the change you're trying to make, and you have to time that correctly, or you'll lose money (or clients) even if you were right. Their case in point example: you could have been absolutely right in 1998 that the markets were headed for a crash, but unfortunately if you pulled your clients out of the market then, you probably wouldn't have had any clients left by the time the crash finally arrived two years later!
Yet when I look at firms that implement tactical asset allocation, this kind of characterization - that you might try to get all the way out of the market ahead of a crash, be "too early" (or just flat out wrong), and lose all your clients - doesn't seem to be the way financial planners who follow the approach are actually doing it.
First of all, the mischaracterized approach of being tactical implies that the planner will make forecasts that completely avoid all market declines; in essence, that tactical asset allocation is about generating absolute positive returns. However, in practice, that is often not the case, not is it at all necessary. Generating effective relative returns - i.e., beating a benchmark - is still not only an acceptable target for success, but almost by definition would mean that the tactical approach that beats its benchmark is beating its passive, strategic alternative. After all, as many planners are aware, saving just a few basis points per year in investment costs and expenses can really add up over the long term; similarly, "merely" generating 1%/year of relative outperformance (being down 19% when the market is down 20%, or being up 11% when the market is up 10%) can increase the growth of your wealth by almost 50% with cumulative compounding over several decades of lifetime saving and investing. Let's not be guilty of applying a double-standard where we measure the value of active management on one scale, and the importance of saving fees and expenses on a difference scale, when it all has the same wealth impact. After all, in a year where the stock market loses 20% in a decline, that means "just" reducing equity exposure by 5% (e.g., from 60% in equities to 55% in equities) can produce an incredibly desirable 1% relative outperformance (by only losing 55% x 20% = 11% of the portfolio in a stock decline, instead of 60% x 20% = 12% of losses), and it's the same benefit as saving 1% in expense ratios. But to say the least, having absolute positive returns as a benchmark is, simply put, quite unnecessary, and substantial value that radically improves a client's success and standard of living over time can still be created with a far less onerous benchmark and far more modest shifts in allocation.
Which, indirectly, leads to the next notable difference between market timing and tactical asset allocation: the magnitude of typical changes, along with the time horizon for those changes. The stereotypical market timer is one who can move "all in" or "all out" of investments at their whim; it could be 100% in equities on Tuesday, 100% to cash on Thursday, and back to 100% in equities again next Monday. Tactical asset allocation, on the other hand, typically implements change in a far more modest fashion; depending on the firm, changes from 2% to 5% are more common, with some firms making changes in the 10% to 20% range. Although the latter may seem "extreme" to many planners, it is still far less than the 100%-in-100%-out style of the stereotypical market timer. In addition, most firms that employ tactical asset allocation have a much longer time horizon; rather than going all-in on Tuesday, out on Thursday, and back in on Monday again, tactical shifts often span time horizons of months or years, leading to "relatively" fewer transactions and allocation shifts that occur more gradually over time. This anchors back to the fact that tactical asset allocators are often looking from a more top-down, macroeconomic perspective, where the factors themselves only change so fast, and take time to be manifested in the markets. This can be contrasted with the market timer, who is often looking over an extremely short-term time horizon, where other factors (short-term technical indicators?) may be driving the process.
Notably, changes in portfolio also don't have to be the "in-market or out-of-market" variety, either. Many tactical asset allocators focus on how their investment selection rotates based on market and economic factors; a highly successful tactical asset allocator may have held only 60% in equities over the past decade and never varied the equity exposure, but if it was small cap value from 2000-2004, international stocks from 2004-2007, defensive consumer staples stocks in 2008, and emerging markets in 2009-2010 during the post-crash rebound, clients may have doubled their money over the decade without any change in overall equity exposure. This may be contrasted with the market timer, who - at least in the stereotypical definition - tends to make changes between stocks and cash (i.e., "in" or "out" of the market), rather than all of the more nuanced shifts that may occur within the equity asset class(es) (or within bonds, or within alternatives, etc.).
Of course, it is still true that any transaction that changes an allocation involves some aspect of "timing" to the execution. But being allowed to simply make any change to the portfolio - which involves a timing to execute - seems to be a poor definition for what constitutes a "market timer" for financial planners. After all, even those who are strategic and passive and only execute changes to the portfolio via rebalancing still noticed that in late 2008, the month, week, day, or even hour that you executed just a "passive" rebalancing trade had a significant impact on the client's returns given the incredible market volatility of those months. If trying to decide whether it is more prudent to rebalance in September, October, November, or December 2008 constitutes "market timing" then I guess virtually all of us are guilty of being market timers; which means to me, that's a pretty useless way to define it, and we need a new definition of market timing.
So what do you think? Do you see a distinction between being tactical and market
timing? Or is it all market timing? Is it possible that being tactical may be appropriate for some planners or clients, even if market timing is still viewed as "risky"?
I agree it is a double standard to expect active strategies to never lose, but I would much prefer a strategy that saves 1% in fees and taxes than one that promises 1% in outperformance. Reducing fees is 100% guaranteed to increase return without increasing risk. A tactical allocation strategy that worked in the past has no such guarantee, and according to most academic evidence will increase risk. Better a bird in the hand than hiring a bird tactician to hopefully capture one for you.
Steven,
What “academic evidence” suggests that tactical asset allocation increases risk?
I’ve never even seen a study that analyzes tactical asset allocation strategies in this context, especially given that most active managers (e.g., virtually every mutual fund manager) is constrained to a style box and couldn’t be tactical anyway.
That aside, how do you define “risk” for these purposes? It’s one thing to say that active management isn’t worth the fees; it’s totally another to suggest that tactical asset allocation systematically increases exposure to asset price declines. I’m not convinced the former is true, have never seen a study suggest it, and I’m not even certain how one would measure that.
Respectfully,
– Michael
The evidence I was referring to is academic theory. Maybe some consider only empirical studies to be valid evidence. Like you, I don’t know of any good data purely looking at the performance of tactical allocation, although the returns of global macro hedge funds are not encouraging.
CAPM suggests that any deviation from the market portfolio has sub-optimal risk/return characteristics, but let’s ignore that. Using Markowitz’s MPT model, investing purely in small cap value stocks or domestic consumer staples will reduce the number of imperfectly correlated asset classes from which you can construct a portfolio. Now if you know in advance that emerging markets had a high expected return in 2009-2010, then of course your portfolio will be less risky. But the average tactical allocator, by definition, will get the average, or market, return. If you can identify the skilled allocators in advance, please let me know your secret! The average tactician will have average returns and above average risk, because their portfolio will be constrained by their sector bets, which on average will add no more value than throwing darts at an iShares product list.
Now the investor that changes their allocation by 5% every 5 years is probably not jeopardizing their retirement, but I would argue that they are still adding risk at the margin.
But I would love to hear more of your thoughts on this Michael.
Steven,
I began to write a response to you here, but I thought you raised such interesting points, I turned my comments into a new blog post! So you can read the lengthy response in today’s blog:
https://www.kitces.com/blog/must-tactical-asset-allocation-lead-to-inefficient-risky-portfolios-not-according-to-markowitz/
Thanks for participating in the conversation! Let me know what you think!
– Michael
Michael:
The diference between tactical a.a. vs. mkt timing is that tactical has obtained the status of legitimate way to engage in active management, while “market timing” is an unjust, disparaging label imposed on active managers by those who are passive indexers.
I don’t like the phrase “market timing”. I prefer to say “market boycotting”. If the PE is too high then I boycott the market until it comes down. I can’t tell you when an over-priced mkt will go down I can only recommend that you avoid it. A prudent investor should only buy with a discount below intrinsic value in order to have a margin of safety. To do that requires waiting for a crash and selling off overpriced assets.
I’m opposed to short term in and out trading of less than 90 days and prefer to use open end actively managed mutual funds.
I do call myself a market timer. All investors time the market, they just do it badly. Whether it’s getting in at the top and out at the bottom, or changing advisors when things “arent’ working”. See QAIB for how bad most are. I frequently get clients 100% in cash and then get back in again, usually many times a month. You can generate returns as good or better that the averages while significantly reducing your volatility. There’s a much better premium for missing the bad times than being in for the good times. Most advisors just don’t have simple strategies to time, nor platforms that make it efficient.
This is the most important investing question today, in my view. I applaud you for getting some discussion started on it, Michael.
I believe that all in this field need to stop apologizing for using market timing strategies and instead embrace the term. The research of the 1960s and 1970s taught us something important — short-term market timing (changing your allocation with the expectation of seeing a benefit within a year or so) rarely works. Shiller’s research from 1981 forward taught a second very important lesson — long-term market timing (changing your allocation in response to big price swings with the understanding that it may take as long as 10 years for this to pay off) ALWAYS works and in fact is required for long-term success.
We need to educate investors that long-term timing is every bit as much a good thing as short-term timing is a bad thing. Long-term timers obtain far higher returns at far less risk. What’s not to like? It’s true that timing has a bad reputation today because of the hundreds of millions in marketing dollars that have been directed to discouraging timing. But we cannot change attitudes by dancing around the issues. We need to stop apologizing for engaging in effective timing strategies and begin singing the praises of the form of timing that works.
People will get the idea soon enough if the message is delivered in a clear way. The problem today is that the message is being muddied by those who suggest timing strategies in a half-hearted or apologetic way.
Thank for kicking off this discussion, Micheal. Every time people think over these issues, we move the ball forward a bit.
Rob
I find it amusing that some planners consider anything other than passive investing to be market timing. What you are describing here as “tactical” is essentially what you find in the teachings of Benjamin Graham. In his book, The Intelligent Investor, he outlines that investors ought to stay between 25% and 75% stocks at all times, and that valuations ought to be the driving force behind that decision. That provides a whopping 50% swing in your allocation to stocks when markets are extremely overvalued versus extremely undervalued. I would hardly call Graham a market timer…which leads me to ask, isn’t this simply value investing?
I submit that this concept is precisely what “value investors” like Grantham, Eveillard, Klarman, de Lardelmelle, Romick, Hussman and Leuthold preach year in and year out.
To your point Steven, there is no reason you cannot integrate a “value investing” strategy using index funds, ETFs, Vanguard or DFA. It doesn’t require “active fund management” to integrate a tactical approach. Furthermore, I completely disagree about your risk comment. You will never convince me that a 60/40 portfolio had the same risk in 2009 as it did in 2007. If you define risk as volatility (as the academic world tends to do), then the portfolio in 2009 actually had more risk. For a long-term investor, I submit that this definition of risk does not make sense. If you define risk as permanent impairment of capital (as value investors do), the opposite is true. A portfolio with higher prices, by definition, must have more risk than the exact same portfolio with lower prices.
Great post,
Joe Pitzl, CFP®