Earlier this week we ran a piece on the difference between Tactical Asset Allocation and passive investing. In this guest post, Michael A. Gayed of Pension Partners, a Tactical asset manager, weighs in.
As we approach summer, I can’t help but think about how people drive. After all, Americans are expected to be on the road to go on vacation as the weather gets warmer. The destination of course is meant to be a source of enjoyment for most. Some will hit the beach, some will drive down to Atlantic City, and yes, some will even visit in-laws (good for you if you find enjoyment from that!).
Ultimately, the destination is what we’re all trying to get to, but how we get to it has varying degrees of risk. We all hope that I-95 won’t be backed up and have traffic so we can go the speed limit (or a bit over it), cruising in the left lane and not slowing down for anything. But anyone that’s driven for a long time knows that’s likely not going to happen. There are going to be periods when there is clear road ahead, when you can go pedal to the metal, and periods when you’ll need to slow down or even stop because of congestion.
Of course you don’t know if you’ll have varying driving speed when you are 1, 3, 5, or 10 miles away, but you certainly can see up to the edge of the horizon out your windshield. You don’t want to be on cruise control if you can see traffic just up ahead!
Investing is no different. Day in and day out we are told that “buy and hold” investing, the idea that one buys for the long-term, is the right way to invest. But that’s no different than being on cruise control the whole way to your destination. Sure, you can hope that you don’t crash and that the highway remains free and clear, but I wouldn’t bet my life — or my financial future — on it.
That begs the question, “what alternatives to ‘buy and hold’ are there?” There certainly are degrees of “activeness” when it comes to investing.
Let’s start off with the basic idea that there are two buckets one can invest in: stocks or bonds. Forget for a moment the mistaken idea that stock picking works and focus instead on the broad asset class. Numerous academic papers, including the most cited Brinson, Beebower, and Hood study conducted in 1986, have documented the idea that asset allocation explains more than 90% of a portfolio’s return. (Here’s a link to the trio’s 1991 update of that paper, “Determinants of Portfolio Performance II”).
What this means is that if you are focusing on stock picking, you’re missing the broader picture.
This is largely why “passive investing,” which focuses on buying index funds such as those based on the S&P 500 (like Vanguard’s VOO) or the Barclays Aggregate Bond Index (like iShare’s AGG), tends to outperform stock picking or bond picking strategies over long periods.
On that assumption, and on the belief that asset allocation set on cruise control is a dangerous way to invest, the next question naturally becomes: what are the alternatives to managing a portfolio if you want to go the passive investing route? Certainly, there are degrees of active investing even with passive funds.
At a minimum is active rebalancing towards target weights. For example, let’s say at the beginning of 2008, you had a mix of 60% bonds and 40% stocks. By the end of 2008, those weightings clearly would have changed as equities collapsed post-Lehman Brother’s demise. An active rebalancer would then have sold off some of their bonds, since bonds would have grown to a much larger chunk of their total holdings than planned, and then bought more stocks. The reasoning is simple, by rebalancing back to target weights yearly, you basically force yourself to buy low and sell high in order to get back to your original allocation.
This certainly would have helped you as equities bottomed in 2009. There are a number of different studies which indicate that a simple annual rebalancing back to target weights can result in an extra 1% to 2% return per year when compared to not rebalancing.
In the context of driving, this is like being in the right lane at all times, but adjusting your speed based on what’s happening around you.
Tactical Asset Allocation
Some drivers and investors choose to be more active in their approach to the destination. Rather than stay in the right lane the whole way, they may tactically switch to lanes which are going faster as they move further along the road.
In the context of investing, this is called Tactical Asset Allocation (TAA). Rather than just rebalancing to target weights once a year or so, tactical investors instead try to maximize the amount of time and capital in investments which are outperforming. Rather than being in a mix of stocks and bonds in 2008, the active tactical investor might have decided it was better to have no stocks at all, and instead buy Oil as it was reaching for a price of $147 per barrel. Or perhaps one would have been 90% in bonds, with a heavier tilt toward Treasuries.
Tactical Asset Allocation involves an active bet that there are periods in time when one can observe one investment performing better than another, and hold that winning investment until a reversal in relative performance occurs. This, of course, does require a high degree of both confidence and competence. There are investment managers that take the Tactical Asset Allocation approach to investing for their clients (including my firm, Pension Partners, LLC.) Others prefer a more traditional rebalancing approach.
Both have the potential to work – its just a matter of how you like to drive.
Michael A. Gayed, CFA, Chief Investment Strategist for Pension Partners LLC and a regular contributor to Seeking Alpha.
Please Note: This article expresses the views of the author and such views are subject to change without notice. Pension Partners LLC has no duty or obligation to update the information contained herein. Further, Pension Partners LLC makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This article is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Pension Partners LLC believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This article, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Pension Partners LLC.
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