Tactical asset allocation is an investment strategy that actively adjusts a portfolio’s composition in response to market conditions. Unlike strategic asset allocation, a passive strategy that maintains fixed allocations at all times, tactical investors may deviate from those percentages to take advantage of a sudden market shift.
For example, a tactical investor who believes the financial sector is poised to gain might allocate another 5 to 10 percent to that sector.
The goal of these adjustments is to increase a portfolio’s risk-adjusted return by reducing overall volatility as an investor moves into asset classes that are expected to outperform and out of those expected to underperform. Markets change all the time and may produce significant imbalances that a savvy investor might exploit, says S. Michael Sury, a finance lecturer at the University of Texas at Austin. For example, he points to a time between 2008 and 2009 when very liquid, closed-end mutual funds had net asset value discounts of 30 to 40 percent, creating an arbitrage opportunity for the tactically minded investor.
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Although tactical asset allocation can be a smart strategy for someone willing to put in the time to determine which asset classes are likely to gain and which to lose, for most people, the risk of making a wrong tactical move is not worth the potential reward. Tactical investors not only must “be open to responding to the opportunities the market provides,” Sury says, but also gauge those opportunities accurately.
Even professionals have a hard time reading the tea leaves. Along with net asset value and price-earnings ratios, tactical investors use market and economic indicators to identify which asset classes are likely to outperform in the near term. For instance, changes in trading volume or earnings growth in a particular investment, sector or asset class can signal a shift in market momentum. Comparing the earnings yields on stocks to nominal bond yields (the fixed interest that a bond pays) can help you determine which to overweight.
Business cycle signs also may be cues. Rising interest rates on short-term bonds, for example, could signal a slowing economy, prompting some tactical investors to move into more defensive sectors. Similarly, a widening spread between high- and low-rated corporate bonds, which implies an increased market aversion to the risk of default and therefore the need for a higher return from lower-rated bonds, also could lead tactical investors to increase allocations in defensive sectors.
In theory, these indicators could enable a savvy investor to make short- to intermediate-term profits. But the more likely scenario is that money is shifted to the wrong place and ends up damaging the investor’s long-term results, says Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta. “While the idea of trying to time market movements to outperform is attractive, this is something no investor has shown the ability to consistently do,” Jacobs says.
[See: 8 Times When You Should Sell a Stock.]
In fact, few professional portfolio managers are able to make the right calls consistently. The average five-year performance of Morningstar’s tactical asset allocation fund category to date is 5.35 percent. Meanwhile, the five-year performance of the Vanguard Balanced Index Fund (ticker: VBIAX) is 9.66 percent. The Standard & Poor’s 500 index’s five-year return is an even higher 12.56 percent.
This doesn’t invalidate the general thesis of tactical asset allocation, which for some investors can be well worth their time, effort and risk, Sury says. But it does underscore the high stakes that lie at the strategy’s core.
The risk is being tactically wrong. Essentially, tactical investors risk “taking large bets that do not pay off,” says Matt Ahrens, a financial advisor at Integrity Advisory in Overland Park, Kansas. When he and his team saw the dollar beginning to weaken at the beginning of this year, they made a tactical decision to overweight international equities by 4 percent. The bet ultimately paid off for their investors as the portfolio returned an extra 0.5 percent through the third quarter of 2017. This relatively small increase in return is proof that “individual investors should not be making tactical changes on their own,” Ahrens says. “There isn’t enough bang for the risk of being wrong.”
Derek Hagen, a financial planner and founder of Fireside Financial near Minneapolis, says the challenge of tactical asset allocation is having to guess the movement of the market correctly twice. You have to know when to alter your allocation and when to bring it back to its original target. Do either of these wrong, and you risk damaging your returns instead of enhancing them.
“Not only may the tactical shift be in the wrong direction, it may also be of the wrong magnitude,” Sury says. “The more frequently an investor makes tactical asset allocation adjustments, the more the portfolio is subject to these errors.”
One common error is reacting to market conditions rather than anticipating them. “Tactical allocation is meant to be forward-looking, and too often individual investors are making backward-looking decisions,” Ahrens says. In his experience, most individual investors make tactical shifts “based upon which sectors or asset classes have been performing the best, and that often leads to them missing most of the ride up and experiencing most of the ride down.”
Any active investment strategy costs more. Tactical investing also requires more trading. “Whether you decide to pick your own securities, or you invest with a manager that pursues a tactical strategy, the fees and expenses involved with such a strategy will be significantly higher than a long-term, low-cost portfolio,” Jacobs says.
Plus, trading in and out of securities can lead to dividends and capital gains that don’t qualify for the preferential 15 percent tax rate, he warns. For this reason, he recommends investors adjust their portfolios based on changes in their life rather than a short-term market outlook.
[See: 7 Things That Can Derail Your Retirement Investing.]
Ultimately, a straightforward strategic asset allocation where asset classes are assigned a fixed weight for the long term is best for individual investors. “By consistently rebalancing back to the target strategic allocation, investors get to trim the asset classes that have gone up and buy the asset classes that have gone down,” Hagen says. “And they do so without predicting the future.”
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How Investors End Up Being Tactically Wrong originally appeared on usnews.com
