Market timing has been derided over the years as a fool's errand, a loser's game that dampens returns by increasing costs (transaction and taxes) and just plain missing out on “big mover” days. In fact, I'd wager that most financial advisors have tried to mollify worried clients over the years by invoking the “time in the market rather than timing the market” dictum. “Mr. and Mrs. Client,” advisors may say, “over the long term, stocks tend to rise. Buy and hold, let the market's natural tendency to rise do its thing. You don't want to get whipsawed, do you?”
Now, after an extraordinarily painful bear market, the likes of which have not been seen since the early 1970s, even the sacrosanct buy-and-hold strategy is being questioned, or outright derided in some precincts. (No wonder: Between 1969 and 2009, an investor in 20-year Treasuries beat an investor in the S&P 500.) “Buy and hope,” as some market timing proponents put it, works great in secular bull markets; not so well in times such as these. It's not necessarily an all out assault on buy and hold, but some market timers are sounding very persuasive these days.
Mebane Faber, a portfolio manager for Cambria Investment Management in El Segundo, Calif., is perhaps one of the more compelling advocates of market timing. (Oops, “tactical asset allocation strategies,” please, since market timing has such a horrible reputation.) Faber, a quantitative manager, is not well known; but, he is lately creating a name for himself. (Cambria manages roughly $50 million in assets — small, yes, but its enjoying surging interest on a sub-advisory basis.) With the publication of a research paper in early February 2007 in the Journal of Wealth Management (that spawned a book, The Ivy Portfolio, released this past March by John Wiley publishers), Faber is getting noticed for advocating what mainstream investment gurus have warned investors against for years: timing the market. (Indeed, over the last 12 months, his paper was downloaded more than 18,000 times from the Social Science Research Network, an e-library of more than 250,000 academic papers from academia's leading thinkers; that makes it the most downloaded SRN paper for the period.)
SHADOWING THE SUPER ENDOWMENTS
Faber is not a hyper-active day trader, vacantly muttering empty market “wisdom,” such as “the trend is your friend.” In his well-received white paper “A Quantitative Approach to Tactical Asset Allocation” and his recent book, The Ivy Portfolio, Faber extols the virtues of building “a core asset allocation of diverse asset classes to generate stable returns in various economic environments.” He says you should follow Ivy-League stalwarts, such as Yale and Harvard, by holding five to 10 asset classes (domestic and foreign stocks, of course, but also real estate and commodities and — if you can get it — private equity, too). That portfolio, using ETFs or mutual funds — fully invested and rebalanced monthly or annually over long periods of time — will do well on its own, Faber says.
But by overlaying a simple timing strategy, an investor can reduce volatility and catastrophic drawdowns (i.e. 2008), significantly improving compound annualized returns. His timing strategy: At the end of every month, the investor checks the 10-month moving average of each asset class in his strategic base portfolio. He buys into those classes that are trading above their 10-month moving averages and sells those classes trading below their moving averages, moving to cash. It's that simple.
The long-term results, as published in his book, are convincing. And now Faber, along with more well-known asset managers, such as PIMCO and GMO, are promulgating their message (an admittedly self-serving exercise for both large, well-known tactical managers). It's a message you are already probably hearing: Diversification isn't enough anymore; investors and their advisors need to be more pro-active with risk management; tactical allocation works.
Does it? Does an advisor really have the ability to move clients in and out of whole asset classes on a regular basis, especially given their disparate investment policy statements? Compliance may frown on market timing as a matter of course, especially in this regulatory environment. On the other hand, with a 36.7 percent decline in the S&P 500 and 35 percent-plus declines in commodities, REITs and foreign stocks in 2008, advisors who couldn't (or simply didn't) stop the bleeding in client portfolios might find what tactical/timing advocates have to say interesting — even persuasive.
“We all grew up in the era of buy and hold,” says one UBS advisor who manages more than $1 billion on a discretionary basis for mostly high-net-worth clients. “Clearly, that hasn't worked. If you're going to sit idle with your client's portfolios through the events and economic reports we've now seen for more than a year-and-a-half, you're crazy,” he says. “Call it market timing or TAA [tactical asset allocation] — whatever. It's self-preservation. I have to make my clients money no matter what kind of market we're in or I'm out of business.”
WHAT IT IS
As defined by a Vanguard institutional research report, TAA is “a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts.” Whether a strategy is driven by momentum in an asset class, by sentiment or by fundamental valuation signals, all are systematic rules-based approaches to investing. The Vanguard report, titled “A Primer on Tactical Asset Allocation Strategy Evaluation,” concludes, “Strategic asset allocation is the critical decision, while a well-designed TAA strategy can add value at the margin.”
That may sound like tepid praise, and, as the study points out, there are many challenges to TAA: understanding the process, evaluating managers to distinguish luck from skill and minimizing costs. On top of those criticisms, there is some compelling research that shows that timing hasn't worked in the past. Burton Malkiel, the godfather of the efficient market theory, says, “I've never believed it makes sense to time the market, and I don't think anyone can consistently do it over time. People are told active management is great because those managers are able to move to cash at the high points of bubbles. But from what I've seen most managers tend to be most bullish at the top, bearish at the bottom.”
Mebane Faber agrees with market timing's detractors about one thing: Most people are terrible at it. “Every study bears that out,” he says. He also allows that market timing can underperform buy-and-hold in a strong bull market. But he says if you follow his strategy with discipline, it works. The version in his Ivy Portfolio is indeed simple. “What we set out to do was demonstrate a very simple method for TAA,” says Faber, who uses the terms market timing and TAA interchangeably.
Michael Kitces, the 31-year old director of research for Pinnacle Advisory Group in Columbia, Maryland, joined Pinnacle in 2002 just as it was changing its focus to TAA. He says the change was in no small part due to a collective interest in understanding market cycles, particularly secular bear markets. “As a group, we became quite a bit less impressed with buy and hold and the idea of efficient markets,” says Kitces. Take 1966, when the Dow was at 1,000; 16 years later, it was also at 1,000. “So you collected dividends for 16 years, but inflation-adjusted you lost money — over 16 years!”
Deju vu all over again? Many commentators agree the medium term outlook for U.S. equities — typically the largest piece of any asset allocation, whether institutional or retail — is not good. One such person is David Rosenberg, a former North American economist for Merrill Lynch who is now with Canadian firm Gluskin Sheff. Rosenberg says we're halfway through a secular bear market that began in 2000. It's another one of the Dow's 18-year cycles that date back 100 years, he says. Sure, there will be cyclical bull markets like there were in the U.S. in the 1930s and Japan in the 1990s, but we're likely in for another disappointing decade.
TAA LITE
Pinnacle isn't an absolute return shop, so its clients have lost money, too, — just not as much as some other clients. Pinnacle runs five model portfolios using 20 to 30 ETFs in each and occasionally a mutual fund for special purposes. Kitces says the moderate allocation portfolio beat its benchmark (a 60/40, S&P 500/Lehman bond index blend portfolio) by 6 percent last year, losing 16 percent compared to 22 percent for the benchmark. He says Pinnacle doesn't time per se. It analyzes economic conditions and considers whether to over or underweight an asset class carefully. Kitces says the current economic environment now is “uncertain at best.” As a result, Pinnacle's five model portfolios are in neutral positioning, he says.
For advisors who don't want to run a tactical portfolio themselves, they can farm out the process to any number of advisors offering sub-advisory services, including Kitces and Faber. But there are other ways to add a tactical component to a client's strategic asset allocation. One of them is with a 10 percent or so allocation to managed futures. Managed futures have been shown to lower risk in a portfolio because of low correlation to most asset classes and have recently achieved attractive returns. (Of course, managed futures have their skeptics, too.)
One thing Kitces and many others we spoke with will not do in their tactical strategies is go completely to cash, as Faber's timing strategy recommends. The problem, they say, is that clients can't handle sitting on the sidelines for long. Pinnacle's lowest equity position was 38 percent in 2008. “As the FA, you have a low probability of being right about the timing of the cash move,” says one FA who manages money for other FAs at his wirehouse firm. “More importantly, clients will live with losing money in down markets but not tolerate not making money when markets move up,” he says. (A hypothetical — and very old — investor applying Faber's strategy to the S&P 500 would have been invested in the market roughly 70 percent of the time, and in cash 30 percent of the time, between 1900 and 2008.)
But another advisor says he's proof that all cash positions aren't always a business killer. Dave Petersen, the founder of Financial Services Advisory in Rockville, Maryland, has $450 million in AUM and says his clients spent nearly all of 1998 (when Long-Term Capital blew up) as well as ten-and-a-half months of 2008 in cash. As a result, even his most aggressive model portfolio, called “tactical growth,” lost just 6.6 percent. His three more conservative portfolios were flat or lost less than 1 percent. Petersen builds his portfolios with mutual funds, usually 8 to 12 of them, and some ETFs, representing a diverse group of asset classes. Based on the volatility of a manager's fund, he sets “stop losses” for that fund — usually between 5 and 8 percent, but always less than 10 percent. If the fund hits the stop loss mark, he moves the assets in that fund to cash. Petersen says he uses a 200-day exponential moving average, as a primary indicator of when to get back into an asset class. For less volatile asset classes, like bonds, he may use a shorter-term moving average. He also employs trendlines, or support and resistance lines as well as relative strength charts, to help indicate buying opportunities. In some cases, he'll use an overbought/oversold oscillator such as the Commodity Channel Index (CCI) as a potential early-warning signal to buy an asset class. His 10-year compound annualized return from 1999 to 2008 in his tactical growth portfolio is 7 percent, compared to -1.4 percent in the S&P 500. And his returns were quite a bit smoother than those of the index as well: his worst monthly return over that time was -9.2 percent; the worst month of the S&P 500 was -21.5 percent.
Petersen acknowledges that his strategy's cash position does test the resolve of clients from time to time. “I lost some [clients] in 1999 and 2007, mainly. It's been the peaks of euphoria where greed has driven a few to ask, ‘Why don't we have more emerging markets? Or tech?’” he says. “We're all about making money and keeping it. And with possibly another decade of sideways markets, it's definitely a case for active management, or, if you want to call it that, tactical,” he says.
