For 23 years, Andrew Costanzo, of Costanzo Financial Group, focused on preserving principal for his clients using fixed instruments, a strategy that lends itself nicely to the tenets of buy-and-hold. But Costanzo doesn't want to have to tell his clients, “Sit tight; ride it out,” as the markets spiral downward, ever again. That became his mantra when the markets collapsed in 2000/2001 and again in 2008.
“Trying to keep people on the boat, they don't want to hear it anymore,” Costanzo says. “They want a life preserver; they want to get off the boat. And that's what a lot of people do if they don't have confidence in your system.”
So earlier this year, Costanzo, who manages $300 million in client assets with Multi-Financial Securities, started to take a more tactical approach to asset allocation. Now, two-thirds of his clients' portfolios are managed tactically, versus one-third strategically.
There's no doubt there's a renewed interest in tactical asset allocation and new products that cater to that method. According to a survey by Cerulli Associates, the number of FAs using either a pure tactical allocation or strategic allocation with a tactical overlay is now at 61 percent, up 8.3 percent from 2010. Cetera, a network of independent advisors, just rolled out five new tactical asset allocation models as part of its new mutual fund/ETF advisory program. And new asset allocation funds and other dynamic asset allocation strategies are popping up every day.
But retail clients can be a tough bunch to satisfy. They want absolute returns in down markets as well as market-beating (relative) returns in good markets; only problem is, you can't have both. It's understandable that advisors would want to deliver a strategy they can tell their clients will help smooth out returns in the current choppy market, but FAs need to be careful what they're promising investors. What's the old expression? Never sell returns, sell process and services.
“I think investors should not think that there's somebody who's tactically going to solve all your problems and be in the right asset classes at the right time,” says Burton Malkiel, Princeton University professor and author of the classic A Random Walk Down Wall Street. “I just don't think anyone can do it.”
Once derided as market timing, will this “tactical” approach really serve to dampen risk or could it be the industry's next embarrassment?
Buy and Hope
Modern Portfolio Theory has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. According to MPT, a portfolio of low- or non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.
But some say the environment has changed. Scott Sampson, president of Sampson Investment Management in Danville, Calif., is one of them.
About four years ago, Sampson started using a separate account version of the Aston Dynamic Allocation Fund (Ticker: ASENX), managed by Bryce James, founder and CEO of Smart Portfolios. The fund uses James' proprietary mathematical process to “dynamically” allocate across a wide variety of asset classes using ETFs in an effort to reduce risk.
It's true: Buy-and-hold does not look so smart right now; it didn't work during the “aughts” — the first decade of the 2000s. (After all, what's so smart about being long the S&P 500 100 percent of the time?) Advisors feel that they simply can't go back to clients a third time in 10 years and tell them to stick to their strategic allocation and keep their eyes over the horizon. “We've now entered a period of time where volatility is much higher, and because of that uncertainty in markets, the old rules don't seem to apply,” says Jerry Chafkin, CEO of AlphaSimplex. “It's not so much that we think that what people were doing before was wrong; it's just it was designed for a period of time that doesn't look like today.”
But buy-and-hold versus tactical has long been debated, especially in these pages, and many say that you can't time the market and win repeatedly over long periods of time and after taxes, fees and trading costs.
Research shows that active management doesn't work. According to Standard & Poor's, for the five years ending June 30, 2011, 58.27 percent of actively managed U.S. equity funds were outperformed by benchmarks. According to a study by Allan Roth, the probability that a single actively managed fund will beat a comparable index fund over a single year is 42 percent. The probability drops to 32 percent for a portfolio of five active funds, and it drops to 25 percent for a portfolio of 10 active funds.
“I've looked at mutual funds in so many different markets, and I can't point to any mutual fund anywhere in the world that's produced a superior long-term record using market timing as its main investment criteria,” says Don Phillips, managing director of Morningstar. Phillips says there have been scores of these types of funds, but many have fallen by the wayside, such as the Lowry Market Timing Fund and the Criterion fund.
Even Vanguard took a stab at it with its Asset Allocation Fund, which it closed in September. For the one-year, three-year, five-year and 10-year periods, the fund has trailed its index. Fran Kinniry, principal of Vanguard's Investment Strategy Group, says the firm decided the fund wasn't living up to expectations relative to a stay-the-course balanced fund.
But Phillips says a number of these global allocation funds have very good track records (see chart, page 46), and some firms are putting their most senior investment professionals on these funds. Putnam Investments, for example, recently launched its Dynamic Risk Allocation Fund (PDREX), which aims to diversify risk across less volatile assets, reducing reliance on equities. It also may invest in commodities and REITs. The question is, how do you know how to pick the winners from the losers? As we learned in the 1990s, overvaluation can last a very long time — just as undervaluation can carry on for years, as the value strategy did in the 1990s. (Value was said to be dead, in fact.)
“Monkeys throwing darts at a dartboard or at an ETF board are going to have an asset allocation,” says Richard Ferri, founder of Portfolio Solutions and author of The Power of Passive Investing. “Some of them are going to come out ahead, some of them are going to come out behind. Does that make the ones that come out ahead smart and the ones that came out behind dumb? No. They're just monkeys; they're all dumb. But some of them by randomness are going to come out ahead.”
Value add is always a zero sum game — some strategies are going to work, some aren't, says Robert Arnott, founder and chairman of Research Affiliates. But Arnott says that if you carefully choose a tactical strategy that has an inherent contrarian principle — meaning it takes incremental risk when others are not — then you can win. “Successful investing is not that difficult; it's just painful.”
Just Marketing?
If evidence shows that you can't time the market, then why are advisors getting more tactical? Ferri believes advisors are redesigning their business models in this way as a marketing tool. But this is not in the best interest of the client, he says.
“To say that, ‘I don't want to go back to my clients and tell them to stay the course. I want to go back to them and tell them we're going to do something different now,’ that's marketing. That's not being an advisor. That's trying to cover your butt because the call you made wasn't very good.”
“It's playing to your emotions as opposed to your intellect,” says Phillips. “The academic literature strongly suggests trying to jump in and out of the market is a fool's game. If you set a long-term strategic goal and you just stay fairly constant and move towards that, you'll do better in the long run.”
A more tactical approach might be easier for clients to swallow, but is it really better for the client in the long run?
“An advisor's job should be to help educate and do what's best for their clients,” says Mel Lindauer, Forbes.com columnist and co-author, The Bogleheads' Guide to Investing and The Bogleheads' Guide to Retirement Planning. “Buy, hold and rebalance and tune out the ‘noise.’ Over the long term, investors who do that will likely outperform 65-80 percent of those who try all these other market-beating schemes.”
Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis and author of The Quest for Alpha, believes the new tactical uprising is simply market timing by another name. “Tactical asset allocation is a loser's game because it's just a fancy word for market timing so people can charge bigger fees for it.”
Swedroe warns advisors not to overpromise performance to their clients. Rather, FAs need to stick to what they can control, including the amount of risk they can take, diversifying those risks, and keeping costs low.
“The only thing you should promise your clients is you will be a fiduciary, giving them the best advice that's solely in their interest,” Swedroe says.
Arnott says advisors owe it to their clients to ramp down their return expectations. On top of stocks and bonds, a well-crafted tactical asset allocation overlay should add modest, incremental returns of 1 to 2 percent, he says. “If you're aiming higher than that, you're naïve.”
In the Trenches
That said, advisors do have their reasons for looking at more tactical solutions, and we can't discount the huge demand for it in the marketplace.
“Now that we're back down 20 percent off those [2009] highs, people are looking into the abyss of perhaps another recession, and they're realizing it's going to be almost impossible to go back to their clients — ‘here we are 12 years later,’ and ask them to continue to be patient,” says Kenneth Solow, chief investment officer and senior partner with Pinnacle Advisory Group. Solow is also the author of Buy and Hold Is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets. “They need a different story to tell from a business perspective.”
Morningstar's Phillips says he can empathize with these advisors because they're the ones who have to have these tough conversations with clients. In other words, applying these academic, theoretical concepts is easier said than done. It makes sense that they would try to avoid some of that pain on the downside, he says.
“Advisors are in the trenches, and they've got to deal with living, breathing, emotional human beings, who are prone to fear and greed,” Phillips says. “You can have the greatest paper results in the world, but if your clients don't stay on board, it's all for not.”
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