Understanding Tactical Asset Allocation

U.S. stocks have returned to record highs in the second quarter, but institutional investors haven’t forgotten the brutal selloff that engulfed the market at the end of 2018. The decline, which briefly pulled the S&P 500 and Nasdaq into bear-market territory, has forced many investors to question the conventional wisdom of strategic asset allocation (SAA), which involves creating target allocations for various asset classes and rebalancing periodically. Institutional investors are now paying more attention to tactical asset allocation (TAA).

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In simple terms, tactical asset allocation actively modifies a portfolio’s strategic asset allocation based on short-term market forecasts. The end goal of this strategy is to take advantage of market inefficiencies across various asset classes. This strategy doesn’t discard the importance of long-term SAA; rather, it uses TAA to overcome significant short-term risk factors.

The rationale behind TAA is easy to understand: to ensure that long-term average returns don’t underperform the market, a focus on total portfolio performance is needed. Case in point: it was relatively easy to outperform the S&P 500 during the dot-com bubble of the late 1990s. However, in the following ten years, stock portfolios would have vastly underperformed the most conservative mix of stocks, bonds and cash.

In practice, TAA shifts allocations between asset classes to boost capital and income. These shifts impact equity regions, bond sectors and other segments of the market. For a fund to be considered for TAA, it must satisfy several requirements, including demonstrating these historical shifts in allocation on a quarterly basis for at least three years.

Investors want to utilize tactical asset allocation to maximize portfolio returns while keeping market risks at bay. The primary focus is on asset allocation, followed by a secondary focus on investment selection. In this way, it differs from other, more common investment strategies such as technical analysis and fundamental analysis.

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Despite all the promise offered by tactical asset allocation, research from Vanguard Group has concluded that “TAA strategies have not produced statistically significant excess returns over all time periods.” This is where mutual funds can help.

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Mutual funds make tactical asset allocation easier by allowing investors to select a mix of assets based on risk tolerance, region, time horizon and other variables. Mutual funds can also provide exposure to specific geographic regions and asset classes that are suitable for TAA strategies. Since mutual funds are liquid instruments and easy to trade, shifting allocations based on prevailing or expected market conditions is relatively easy.

One of the most successful mutual funds for technical asset allocation is the Meeder Muirfield Fund (FLMFX), which aims to provide long-term capital appreciation.

The Putnam Dynamic Asset Allocation Conservative Fund (PACAX) seeks total returns consistent with the preservation of capital, which gives it a high fixed-income focus. The Sector Rotation Fund (NAVFX) invests in exchange-traded funds (ETFs) with exposure to various domestic and foreign markets, which satisfies geography-based TAA strategies. Other leading TAA mutual funds include the AB Global Risk Allocation Fund (CABNX) and the Lazard Opportunistic Strategies Open (LCAOX).

It’s important to note that selecting mutual funds for tactical asset allocation doesn’t eliminate risks from the investment process. It’s important to reflect on the history of bear markets when selecting any TAA strategy as this will help you determine whether a particular asset can help you mitigate losses during severe market declines.

In general, a TAA strategy involving mutual funds should consider performance, risk tolerance and time horizon. On the topic of performance, TAA mutual funds must be evaluated for variance (i.e., how closely they represent the performance of major asset classes). With respect to risk tolerance, a mutual fund TAA strategy will be used either as a single-portfolio solution or part of a much larger investment strategy. Choosing the right time horizon is also crucial because TAA portfolios can have two extremes: on the one hand, they can mirror day trading strategies, and on the other, long business-cycle periods. Investors should select a time horizon that meets their underlying goals, objectives and risk tolerance.

The jury is still not in on whether technical asset allocation strategies are the best approach for long-term capital preservation and market-beating returns. However, investors should seriously consider TAA strategies in the coming years as the bull market begins to slow.

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