A recent article in The Wall Street Journal contained a headline that very likely frightened many investors — and in my opinion, that’s precisely what it was meant to do. Otherwise, why inform investors that “U.S. public pension plans and mutual funds are sheltering more of their holdings in cash than they have in years, a sign of growing stress in financial markets.”
According to the article, as of September 30, 2015, pension funds held the highest cash levels as a percentage of assets since 2004. And for mutual funds, the percentage of assets held in cash was the highest for the end of any quarter since at least 2007.
It went on to warn investors that these cash holdings “are a potentially bearish indicator.” It also described how several large pension plans had significantly raised their cash holdings. For example, New York City’s plan has tripled its cash holdings during the past 18 months, and the South Dakota Retirement System raised its cash holdings to more than 20% through the middle of last year.
Cash Balances Predict Market Returns?
Scary headlines and stories such as these certainly attract investor attention. And that’s why they are written — not because they convey any useful information but because bad news sells. Before acting on any such information, you should first ask if there’s any evidence on the ability of pension plans and mutual funds to “tactically allocate” among stocks, cash or safe bonds. With that in mind, I dug into my files to see what the research can tell us.
We’ll begin with a look at whether cash balances are a good predictor of future market returns. If they are, we should expect to observe low cash balances at market peaks and high cash balances at market bottoms. While now a bit dated, a study by Goldman Sachs examined mutual fund cash holdings from 1970 to 1989. They found that mutual fund managers miscalled all nine major turning points. It’s hard to get all nine turning points wrong if you tried! We can also look at results from mutual funds that tactically allocate.
Tactical Asset Allocation
Tactical Asset Allocation (TAA) is an investment strategy that gained great popularity in the 1980s and 1990s. Its objective is to provide better-than-benchmark returns with (possibly) lower volatility. This, hypothetically, is accomplished by forecasting the returns of two or more asset classes and varying the exposure (percent allocation) accordingly. The varying exposure to various asset classes on which TAA depends is based on economic and market (technical) indicators. A TAA fund would then be measured against its benchmark.
Although a given benchmark might be 60% S&P 500 Index and 40% Lehman Bond Index, the manager might be allowed to have his or her allocations range from 50% to 5% for equities, 20% to 50% for bonds, and 0% to 45% for cash.
In reality, TAA is just a fancy name for market timing. By giving it an impressive name, however, Wall Street seems able to charge high fees. Let’s see if the high fees are actually worth the price of admission. A study found that for the 12 years ending 1997, the S&P 500 on a total return basis rose 734%, but the average equity fund returned just 589%. The average return for 186 TAA funds was a mere 384%, or roughly half the return of the S&P 500 Index.
Morningstar has also studied the returns of TAA funds. In one study, they examined the returns of 163 TAA funds covering the period ending July 2010. It is important to note that they found that 39 of the funds no longer existed (because of mergers or liquidation). Of the surviving tactical strategies, the median life span was just 37 months. The study also found that TAA funds generally failed to deliver better risk-adjusted returns or downside protection than a traditional balanced index portfolio split 60/40 between stocks and bonds, respectively. For example, 64 of 92 TAA funds (70%) that were at least a year old had worse since-inception performance than the passively managed Vanguard Balanced Index Fund (VBINX), with the average underperformance being 2.6% per year.
Morningstar then updated the study through the end of 2011. They compared the returns of TAA funds to Vanguard’s Balanced Index Fund (VBINX), which passively invests its assets in a 60/40 stock/bond mix. The following is a summary of their conclusions:
- Very few TAA funds generated better risk-adjusted returns than VBINX.
- Just 9 of the 112 TAA funds in existence over the period from August 2010 through December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns).
- Only 27 of the funds experienced a smaller maximum drawdown (the majority experienced larger peak-to-trough declines).
- Only 14 of the 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring/summer 2010 correction, and the recent European debt-related downturn. Put another way, only 17% of the funds consistently provided the insurance for which investors were paying.
And here’s additional evidence from a more recent study by Morningstar. Over the three years ending July 2014, TAA funds gained an annual average of 7.8%, or 3.8% per year behind their benchmarks.
And finally, we’ll look at a study that examined the ability of mutual funds to protect investors from bear markets. The study appeared in the Spring/Summer 2009 issue of Vanguard Investment Perspectives. The study, which defined a bear market as a loss of at least 10%, covered the period from 1970 through 2008. The period included seven bear markets in the U.S. and six in Europe. Once adjusting for risk (exposure to different asset classes), Vanguard reached the conclusion that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection and market timing proves a difficult hurdle to overcome.”
They also confirmed that past success in overcoming this hurdle does not ensure future success. Vanguard was able to reach this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias.
And in case you think pension plans are better than mutual funds at the game of TAA, Charles Ellis, in his book, “Investment Policy,” cited a study on the performance of 100 pension plans that utilized TAA and found that not one single plan benefited from their efforts. Not one. Even randomly we would have expected some to succeed. Yet, none did.
The Bottom Line
The bottom line is that stock market forecasts have about as much value as George Carlin’s Hippy Dippy Weatherman’s forecast: “Tonight’s weather is dark, followed by widely scattered light in the morning.” Investors are well-served to heed this warning from behavioral economist Richard Thaler in his book, “The Winner’s Curse”: “If you are prepared to do something stupid repeatedly, there are many professionals happy to take your money.” The evidence shows that the winning strategy is to follow Warren Buffett’s advice to avoid market timing efforts, but if you just can’t resist doing so, then at least be a buyer when others are panicking and be a seller when others are greedy. You can accomplish that by having an investment policy statement and adhering to it, rebalancing as required.