Whether they go by such names as "unconstrained," "tactical asset allocation," "absolute return," or "go anywhere," Wall Street touts the advantages of funds that have the freedom to shift asset allocations to wherever they see the best opportunities. It certainly sounds appealing. And investors must believe these funds have advantages as the number of such funds grew from 61 in January 1998 to 110 as of June 30, 2013, according to Vanguard's January 2014 paper "Broader opportunities, same limited results: An analysis of go-anywhere funds. And total assets for this group of funds increased six fold, from about $60 billion to $356 billion over the same period.
Have investors been rewarded with superior performance for their belief in the advantages of such funds? Vanguard's research team sought the answer to that question in their recent research paper. Vanguard compared fund performance against the following: a passive 60 percent equity/40 percent bond benchmark and the funds' stated benchmarks, "truer" benchmarks using both style analysis and factor regression, and also to traditional active balance funds.
Regardless of the type of analysis used, they found no excess returns or alpha relative to the stated or implied benchmarks for go-anywhere funds. For example, Vanguard found that relative to a passive 60 percent equity/40 percent bond benchmark, the median monthly excess return of the go-anywhere funds was -0.11 percent. Even compared with the official fund benchmark (and funds are notorious at choosing benchmarks which are more easily beaten) the median monthly excess return was -0.04 percent. Relative to risk-adjusted benchmarks they found that go-anywhere funds produced zero excess return. Vanguard concluded: "As has been the case with other active strategies, the majority of the funds underperformed, net of costs, implying that even with a broader opportunity set, consistent alpha is rare."
Vanguard's findings provide clear evidence against the "conventional wisdom" that a broader opportunity set results in superior performance. It also supports the findings of prior research on the subject. For example, Morningstar examined the returns of 163 Tactical Asset Allocation funds covering the period ending July 2010. It's important to note that 39 of the funds no longer existed (because of merger or liquidation). Of the surviving tactical strategies the median life span was 37 months as of July 31, 2010. Morningstar found that the TAA funds generally failed to deliver better risk-adjusted returns, or downside protection, than a traditional balanced index portfolio split 60/40 between stocks and bonds, respectively. For example, 64 of the 92 (70 percent) TAA funds that were at least a year old had worse since inception performance than the passively did Vanguard's Balanced Index Fund (MUTF:VBINX), with the average underperformance being 2.6 percent per year.
Morningstar updated that study through the end of 2011. They compared the returns of TAA funds to Vanguard's Balanced Index Fund (VBINX) which passively invests its assets in a 60/40 stock/bond mix. The following is a summary of their conclusions:
- Very few TAA funds generated better risk-adjusted returns than VBINX.
- Just 9 of the 112 TAA funds in existence over the period August 2010-December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns).
- Only 27 of the funds experienced a smaller maximum drawdown (the majority experienced larger peak to trough declines).
- Only 14 of the 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring/summer 2010 correction, and the recent European debt-related downtown. Put another way, just 17 percent of them consistently provided the insurance investors were paying for. (Morningstar Advisor Feb/March 2012)
In going through my files on the subject, I found a study on Tactical Asset Allocation funds that David Dreman cited in his book Contrarian Investment Strategies (p.57). The findings were that for the 12 years ending 1997, while the S&P 500 on a total return basis rose 734 percent, the average equity fund returned just 589 percent, but the average return for 186 TAA funds was a mere 384 percent, about half the return of the S&P 500 Index. I also found a study cited by Charles Ellis in his book Investment Policy (2nd edition). That study found that of 100 pension plans that engaged in Tactical Asset Allocation not one single plan had benefited from their efforts.
The following is perhaps the most interesting bit of evidence against the likelihood of success of such funds. On September 30, 2011, Vanguard announced that it was closing one of its worst performing funds, the Vanguard Asset Allocation Fund (VAAPX), firing its adviser, Mellon Capital Management, and transferring the remaining $8.6 billion in assets to another fund, its Balanced Index Fund (VBINX), that follows a passive investment strategy. Introduced in 1988, the Asset Allocation fund was free to invest up to 100 percent of its assets in either U.S. stocks, bonds, or money market instruments. The fund tactically shifted its asset allocation to take advantage of the "best" opportunities. Unfortunately, the fund underperformed its moderate risk target by almost 3.5 percent a year over its last 10 years. And it lagged 96 percent of its peers over the past five years, and 79 percent over the past decade, while taking more risk.
The failure of the VAAPX to achieve its objective highlights just how difficult it is for active managers to generate alpha after the expenses of the effort. Remember, Vanguard is one of the largest money managers in the world, with tremendous resources at its disposal. In choosing the manager to advise the fund, you can be sure that it employed its deep team of analysts. Yet, they failed to find a manager which would generate future alpha. What advantage do your financial advisor have over Vanguard that would allow you to believe that you are likely to succeed where they failed? Do you have more resources than they do? Are you smarter than they are, or work harder? If you are honest with yourself the answer should be that you don't have any advantage, and neither does your advisor, if you have one.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.