Should We Be Tactical?

By Elisabetta Basilico, PhD, CFA and Preston McSwain, December 20, 2021

All want to add value in their various endeavors, and many offer ideas on how to enhance results. This is true in almost everything we consume – a better way to work out or a twist on a classic recipe.

In the investment world, arguably the most famous work done on what adds value to total portfolio performance was conducted by Brinson, Hood, and Beebower, which they detailed in a 1991 paper titled, Determinants of Portfolio Performance. The team of researchers developed what has become the generally accepted framework on how to evaluate what drives investment performance, articulating the following three key activities that an investor, manager, or allocator can employ:

Strategic Long-Term Asset Allocation – Establishing Investment Policy Statements (IPS) that set long-term targets for each asset class (equities, bonds, etc.)
Tactical Asset Allocation – Market timing decisions that deviate from long-term IPS targets and tilt allocations to overweight or underweight an asset class
Manager Selection – Employing a process that strives to find managers that can outperform markets or asset classes and tactically implement or make changes among them at the correct time (picking so-called active managers)

A new paper is now out about number two, and we will touch on number one at the end.

Before we do, however, let’s briefly revisit number three – what the evidence says about investment professionals’ ability to select managers at the correct time, who can outperform the market going forward.

In 2019, we published an article asking this question: Are Selectors Good at Selecting?

Our paper was based on an in-depth study conducted by researchers from the Saïd Business School at the University of Oxford, with assistance from leading finance figures at MIT, and data from well-respected firms such as eVestment and Greenwich Associates. In addition, we touched on work from Finance Departments at St. John’s University and New York University.

What did these peer-reviewed research studies show – have leading industry professionals and well-resourced and focused teams been able to find outperforming strategies?

As we wrote, unfortunately, for many of us who have worked in the field for many years, the answer is brutal:

“No”

After analyzing the recommendations of investment consultants, who represented 90% of the institutional U.S. manager selection market, researchers found no statistically significant evidence that their fund recommendations outperformed.

In addition, fund selection teams inside large investment management firms were found to pick funds that consistently and significantly underperform.

Throwing even more doubt on the ability of any of us to be able to find outliers at the correct time, last year we highlighted more research in a piece we titled Trillions of Influence, which investigated whether the influencers of finance (global institutional investors) are good at selecting top managers.

The answer was also tough for many to take.

“No – again”

This, and other industry research, continues to strongly suggest that manager selection activities continue to be what Charles Ellis, the founder of the global manager analysis firm Greenwich Associates, and long-time head of Yale’s Investment Committee, has called a Loser’s Game.

A recent paper titled, Is Tactical Allocation a Winning Strategy?, allows us to now comment on number two – the ability of professionals to add value by tactically tilting a portfolio away from long-term IPS allocation targets.

Researchers looked at the performance of institutional quality funds run by investment firms who use a multitude of resources and processes to assess the attractiveness of various asset classes and change their weights in portfolios – what are called Tactical Asset Allocation (TAA) Funds.

After analyzing the risk-adjusted returns of over 100 TAA strategies from 1994 – 2016, looking at Sharpe and Sortino ratios as compared to a number of domestic and international benchmarks, the study found that TAA funds consistently underperformed.

Some suggest that tactical moves are indeed difficult to implement in bull markets but say that a TAA approach helps protect portfolios in bear markets and adds value during a financial crisis.

In the author’s own word, however, this is what their research showed when looking at the actual performance of TAA funds.

“We found that tactical allocation funds had significantly negative alpha during the entire period, including during the 2008 financial crisis. Our findings indicate that tactical allocation funds did not outperform the benchmarks, and investors would have been better off with passively managed funds that followed benchmark indexes.”

To try to find out if fees were the reason for underperformance (a TAA approach can be expensive – average costs were found to be 1.4% per year as a percentage of assets under management), they also analyzed the performance of TAA funds gross of fees. As before, the research found no evidence of Alpha.

As with the manager selection studies we reviewed, the results from this analysis of TAA strategies have been confirmed by other academic papers, such as one titled, Static Indexing Beats Asset Allocation. The title does not bury the lead, as researchers from Duke University found the following:

High Fees and Taxes – TAA funds are more expensive and have higher turnover, which can make them less tax-efficient
Underperformance – TAA funds underperform long-term static IPS driven index strategies, significantly, ranging between approximately 2-5% per year.

This all brings us back to the start and number one on our list – the value of setting long-term IPS asset allocation targets and sticking to them, what we have called The Simple Alternative.

Many suggest that the so-called Brinson study said that more than 90% of performance comes from asset allocation decisions.

We understand why this is suggested, as many tout an ability to add value with their asset allocation process. This, however, is not what Brinson and his fellow researchers were really saying.

The study suggested that, after looking at the performance of a sizable sample of large, well-resourced institutional investment funds, the evidence at the time showed that active decisions related to tactical asset allocation and manager selection did little to improve performance.

As more and more data has arrived and better analytical tools have been developed, we continue to find similar things – active investment decisions do not seem to add much value. In contrast, they seem to increase the probability of underperforming.

In saying all of this, we are not suggesting that we should ignore significant events that do happen or not keep an eye out for unique opportunities. We should.

Based on the continued evidence, however, we should also be open and humble about our ability to outperform the broad market.

The probability of adding value through tactical asset allocation or manager selection decisions is very low, as the probability of getting it wrong is very high.

How to Actively Add Value – Research Roundtable

What Would Yale Do If It Was Taxable? – Trust & Estates

What Needs to Change? – Research Roundtable