Vanguard Threatened by Tactical Asset Strategies?

Thanks to a reader for bringing this back to our attention. Today we want to highlight an intriguing research piece from back in 2006 from index-fund giant Vanguard. Back then, they put out an interesting white paper on evaluating tactical strategies entitled, "A Primer on Tactical Asset Allocation." The fact that they would publish such a thing in the first place speaks volumes as they could possibly perceive a threat to their bread and butter business of low-cost buy and hold index investing. And while the piece was written nearly 3 years ago, it becomes all the more interesting given the events that have transpired since its publication.

The adage of 'buy and hold' has come into question with the recent jaw-dropping market declines of 2008 and many investors are re-evaluating their strategies and methodologies. As such, talk of other strategies (including tactical asset allocation) has begun to pick up and the argument has intensified.

While we highly doubt Vanguard would ever openly admit they perceive this to be a threat, it is curious. Did they publish a 'cautionary advocacy' paper in an attempt to cut this argument off at the pass? It almost seems as if they published such a piece because they were beginning to feel some heat. The question now is, has that heat intensified? We'll have to look around to see if they've released any follow-ups or additional research on the subject matter given the rough year the indexes had in 2008. While it's only natural for Vanguard to come defend their turf, this debate could very well be just beginning and could wage on for many years.

The introduction to the paper reads as follows,

Many pension funds, endowment funds, and other institutional investors are concerned that equities - typically their largest asset allocation - will have lower average returns over the next decade. In this environment, many investors have questioned the wisdom of thinking about asset allocation solely in strategic terms and have shown renewed interest in tactical approaches.

Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiences or temporary imbalances in equilibrium values among different asset or subasset classes. Over time, strategic long-term target allocations are the most important determinant of total return for a broadly diversified portfolio. TAA can add value at the margin, if designed with the appropriate rigor to overcome significant risk factors and obstacles unique to the strategy. Our results show that while some TAA strategies have added value, on average TAA strategies have not produced statistically significant excess returns over all time periods.

Interesting premise indeed. They then go on to address these issues in a 12-page white paper where they examine tactical asset allocation and the pros & cons. In the end, their paper then concludes the following:

As we have highlighted, consistently predicting systematic risk is challenging at many levels. SAA is the critical decision, while a well-designed TAA strategy can add value at the margin. However, successful TAA requires rigorous methodology. Understanding the TAA investment process, using quantitative performance-evaluation metrics to distinguish luck from skill, and minimizing costs are essential to the success of TAA strategies.

Embedded below is the entire Vanguard presentation:



Alternatively, you can download the .pdf here.

In the end, we're sure this isn't the last we'll hear of this discussion/debate and we look forward to further research to be presented by both sides of the argument. While Vanguard wouldn't openly admit that they are wary of a threat, we certainly see how this paper could be perceived as such... especially now.

For more reading on the subject, we highly suggest checking out various resources from Mebane Faber. In particular, his book The Ivy Portfolio details the endowment model of investing and even examines hedge fund portfolios, much like we do here at Market Folly on a daily basis (see our review of the book here).

Additionally, Mebane covers various strategies on his well-known blog World Beta. Lastly, he is also a portfolio manager at Cambria Investment Management and co-founder of Alphaclone, a hedge fund replication tool.

Comments

[Roger Schre...:]

Isn't it about time to PUT UP OR SHUT UP. All this debate is exhausting and only leads to more debates. Let's see who will take my challenge from the passive investment community. Bogle has had my challenge (below) in front of him for over a month and has not responded. Is there a reason? Of course there is! He can't win!

My guess there isn't a passive manager out there who will take my challenge, because they are at such a HUGE disadvantage "riskwise." Stop debating. Let me prove it.

Passive investing is high risk, and investors who accept it are going to continue to continue to suffer great losses from time to time. No one in their right mind drives their car 24/7; no one in their right mind drives without brakes. Life is all about making adjustments as necessary. No conservative investor should be told to sit there passively as their retirement assets disappear. No one should tell them to do so.

Sure active management is hard. So what. So is living, advancing your career, growing your family, and raising your children. (I hope you aren't passive about those things too!)
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My $100,000 Challenge to John Bogle
Index investing doesn’t work in the real world of inefficient markets.

By Roger J. Schreiner (Email: [e-mail])

His disciples call themselves “Bogleheads,” and cling to his “Pillars of Wisdom” as though they were the Ten Commandments. Those in the media adore him and treat his words like gospel. He’s an icon—a God-like figure to thousands of investors.

John Bogle is the founder of The Vanguard Group, and launched the first index mutual fund in 1975. Since then, he has dedicated his career to encouraging investors to “own the market” by investing in index funds. He stresses the importance of asset allocation and low fees within a passive, buy-and-hold investment approach. There is no doubt that Mr. Bogle is sincere and has noble ambitions, but I believe his unwavering faith in the markets is misplaced.

Today, he is taking up what many are calling his final crusade. On February 24, he appeared before a Congressional committee in Washington, D.C. to tell lawmakers about his vision for “an independent Federal Retirement Board to oversee both the employer-sponsors and the plan providers, assuring that the interests of plan participants are the first priority…Our Federal Retirement Board should not only foster the use of broad-market index funds in the new defined contribution system but approve only private providers who offer their index funds at minimum costs.”

Mr. Bogle wants Congress to overhaul our retirement system by “limiting investment choices” for workers’ retirement plans and providing “more understandable options.” Under his plan, “only private providers” (such as Vanguard) would be “approved” investment vehicles.

If you’re not sure which investments are right for you, don’t worry; John Bogle knows. If he has it his way, a Federal Retirement Board will make your investment decisions for you. Doesn’t Mr. Bogle realize that shareholders in his index funds had their retirement plans decimated last year? Do you really want him guiding your investment decisions? Nothing personal, Mr. Bogle, but I think buy-and-hold has failed—it doesn’t work.

On June 19, in an interview with IndexUniverse.com, Bogle was asked, “Do you believe that there are environments that are more favorable to active management than passive management and index investing?” His response was clear. “There is no way that active managers can possibly have an advantage no matter what the circumstances are. It is just statistically, mathematically, tautologically impossible.”

My $100,000 Challenge

I hereby challenge John Bogle to a friendly wager. I want to bet $100,000 of my own money that my active investment approach can outperform his passive one.

I am challenging Mr. Bogle directly because he has the loudest voice in the industry. However, my challenge is also open to other passive investors and managers. I have set aside $1,000,000 and am ready to accept up to ten challengers. I have $100,000 earmarked for my contest with Mr. Bogle and another $900,000 waiting for nine others who want to accept the challenge.

The Wager: Both Mr. Bogle and I will place $100,000 in an escrow account at the bank of Mr. Bogle’s choice. At the end of the wager, the winner gets his $100,000 back and the loser will contribute his $100,000 to the winner’s favorite charity in his name.

The Portfolio: Mr. Bogle is free to construct his own portfolio using the index funds of his choice. I will create an exact replica of Mr. Bogle’s holdings for my portfolio. During the contest, Mr. Bogle must passively hold the assets in his portfolio and, in my portfolio, I will limit myself to trading the same assets. As an active manager, I will be able to use cash in my portfolio to help control risk. Of course, Mr. Bogle can use cash too. If he wishes, a website can be maintained so that the public can follow the portfolios and/or the results. There will be complete transparency.

The Time Period: Mr. Bogle can choose the length of the contest—anywhere from one year to a few years, or as many years as he wishes.

Fees and Expenses: Mr. Bogle’s portfolio will incur no (0%) annual management fees. My portfolio will have the disadvantage of incurring a 2% annual management fee, in addition to any transaction costs. We will use a tax-deferred, retirement account structure, so there are no tax implications for short-term capital gains.

The Results: Risk and return are the most basic and logical measures of investment success. In order to win the contest, a portfolio must have both higher return and lower risk. To calculate risk and return we will use the statistical measures of total return and standard deviation.

Mr. Bogle? Well, there you have it. Since you believe “there is no way that active managers can possibly have an advantage no matter what the circumstances,” my $100,000 must seem like free money to you. I’m waiting for your call. I’m not holding my breath though, because I am sure you will find a reason to back down. Of course, if you do, that will help prove my point—that my active investment process is superior to your high-risk “buy-and-hope” approach.

Any passive investor who believes he or she can generate a safer and higher return in their buy-and-hold portfolio than I in my active portfolio has an opportunity to relieve me of $100,000. I’m giving the passive investor all the choices, except the one they saddle themselves with—the burden of not managing their money.

We have created a web page dedicated to “My $100,000 Challenge to John Bogle” at scminvest.com/100k. There we will post the names of everyone (with their permission) who takes me up on my challenge and you can sign up to receive an e-mail alert. You can post your comments, ask me a question, and take our “Active vs. Passive Survey.” There is also a link for a free subscription to our Dynamic Investor newsletter.

Talk is Cheap

I’ve been writing about the flaws of passive investing for over twenty years, but to what end? Articles, debates and media interviews cannot settle the longstanding dispute between active and passive investors. Talk is cheap.

If John Bogle is a consumer advocate, he is also a lobbyist promoting the products of the company he founded. Unfortunately for investors, he has the ear of lawmakers in Congress, most of whom do not truly understand investing. I believe Bogle’s investment philosophy is dangerous to investors’ retirement savings, as evidenced by the results of last year. It is based on old, flawed investment models like Modern Portfolio Theory, the Efficient Market Hypothesis (EMH), and the Random Walk Theory. A proper reading of today’s financial research suggests that these theories are unfounded. To some in our industry, that’s blasphemy—but it’s what I believe to be the truth.

Passive investing is simply ill-equipped to handle the unpredictable events and market volatility we have experienced over the last ten years—it ignores reality. Professor Robert Shiller of Yale University has shown that the instability of asset prices is much greater than is predicted by EMH. That is, where the EMH suggests that passive exposure to investment markets are a way to control risk, real-life experience (the best kind of evidence) shows that markets are actually the source of risk! Even Eugene Fama himself, the father of EMH, recently admitted, “markets are not entirely efficient.” In a recent interview with David Salisbury he said, “market efficiency is a simplification of the world, which does a good job on almost everything, but some things it doesn’t do a good job with.”

The problem with building an investment strategy around the Efficient Market Hypothesis (and the other theories EMH supports) is that it only takes one event—one market crash—to wipeout your retirement savings. Every investor’s time horizon is limited—they don’t have forever to wait for markets to recover.

On August 7th, John Mauldin, an economist and author of the newsletter Thoughts from the Frontline, shared his opinion on EMH. “The Efficient Market Hypothesis, according to Robert Shiller, is one of the most remarkable errors in the history of economic thought. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brainwashing the innocent. Robert Arnott (who oversees $31 billion at Research Affiliates) tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH—pretty much everyone’s hand was up. Then he asked how many of them believed it. Only two hands stayed up!”


Baffle a Boglehead: Use Facts and Logic

Bogleheads won’t admit it, but indexing is high-risk and has delivered low returns historically. According to CrestmontResearch.com, from 1900 through 2008, the stock market has returned just 5.8% on an annualized basis (including dividends and adjusted for inflation). To capture that 5.8% return, investors had to suffer devastating losses along the way, including an 89% loss (1929-32), a 48% loss (1973-74), another 49% loss (2000-02) and, most recently, a 57% loss (2007-09). It took investors 25 years and almost 900% gain just to break even after the 1929-32 bear market. How many years is it going to take Bogleheads to recover from the 57% loss of 2007-09? How much time do you have? See attached chart: “Impact of Losses”

Every quarter, in our Dynamic Investor newsletter, we publish “SCM’s 5 Rules for Investment Success.” We think they are so important that we print them every quarter—we want investors to read them time and time again.

Our Rules for Investment Success are very different from John Bogle’s Pillars of Wisdom. The glaring difference is that our rules are focused on risk management and an acceptance of uncertainty about the future. Bogle’s Pillars of Wisdom hardly acknowledge that investing is risky. His first pillar is: “Investing Is Not Nearly as Difficult as It Looks.” Oooo-kay. I don’t know about you, but if Mr. Bogle is going to work from that premise, I don’t want him anywhere near my retirement savings!

In contrast to Bogle’s first pillar, our first rule is “Avoid Significant Loss.” The man known as the most successful investor of all time, Warren Buffett, agrees. He reminds investors often of his first two rules: “Rule #1: Never lose money. Rule #2: Never forget rule #1.”

“I May Be Wrong But I Doubt It.” —Charles Barkley, 11-time NBA All-Star

There are two reasons why I am not concerned about losing the challenge. First and foremost, because active management is adaptable, it has a huge tactical advantage over passive indexing—sophisticated investors understand this. The risk management benefit, which is inherent in our investment process, gives us an edge that passive investing cannot overcome.

Secondly, it is highly unlikely that John Bogle or anyone else will accept my challenge. I hope he does, though, because it will be a great opportunity for us to raise money for our charities. If passive management truly is superior, or has some kind of built-in advantage, I won’t have any trouble finding ten passive managers to accept my challenge.

To be perfectly clear, active investing does not insure success, and it certainly does not guarantee investors will profit. No investment manager can make such a claim, no matter how long the investment time horizon and no matter who is running the portfolio. By challenging Mr. Bogle, my objective is simple: to prove to everyone—especially individual investors who have been misled by the mainstream financial services industry for far too long—that active investing can be less risky than buy-and-hold. The proof will come when no passive manager accepts my challenge. If someone does, then I will have the opportunity to prove it with my results.

A Safer Way to Reach Your Retirement Goals

If you look objectively at the history of financial markets, it becomes clear that passive, buy-and-hold investing is a high-risk, low-return endeavor. Investors who are close to or in retirement don’t want high risk and unpredictable returns. They want low risk and more predictable returns. For retirees who own tax-deferred retirement accounts, such as IRAs, active management may offer lower risk and more consistent returns.

Investors who utilize active investment strategies in their retirement accounts can move between stocks, mutual funds, ETFs and cash with no tax consequences and with little or no transaction costs. The performance of our active investment strategies speaks for itself. For complete performance information on all of our investment models, please visit our website, or contact us directly.

Investors must unlearn what people like John Bogle have been telling them. The greatest threat to your retirement is uncertainty of the future—it’s the next credit crisis, the next financial crisis, the next recession. If you accept buy-and-hold, you must expect that, at some point, your retirement savings will experience a devastating loss. I always tell investors, “Your investment process must include an exit strategy, otherwise, you shouldn’t be invested in the stock market.”

While our past is certain, the future is unknowable. Bogle’s approach is reckless and irrational because it assumes the market will provide positive returns to all investors. There is no guarantee that returns will be positive no matter how long you invest. My advice to you is to find an investment manager who truly understands risk and has a plan for both good and bad markets. Find a financial advisor that is confident enough to take on today’s uncertain markets, but is humble enough to know what he does not know.

Nov 04 11:41 AM