- Monday’s article in the Wall Street Journal highlights the pros and cons of tactical funds at Ivy, PIMCO, and Vanguard.
- Tactical funds are great for investors who understand the limits of the approach.
- It's important to note that investors have to do a lot of homework, so one might be tempted to just use ETFs.
- Target-date funds offer a cautionary tale for tactical funds: Both are prone to unrealistic expectations and suitability issues.
- Vanguard’s exit confirms my opinion that tactical funds are like drugs: powerful when used correctly, but hard to control and dangerous when used off-label.
Ivy vs. PIMCO
There is a variety of opinions as to what constitutes a tactical fund, but they typically have a flexible, “go-anywhere” mandate to invest in the major asset classes across the globe. Tactical funds offer insights about capital markets, and the tilts in a fund are a valuable signal about how to execute a bullish or bearish stance. And who doesn’t enjoy reading commentaries from PIMCO?
In any case, Monday’s WSJ article by Karen Damato focused on two of the largest tactical funds with the best 5-year track records: Ivy Asset Strategy C (WASCX) and Pimco All Asset Inst’l (PAAIX). Both funds have returned between 5% and 6% over the last five years, though Ivy has an expense ratio of 1.74% versus 0.88% at Pimco. More importantly, Ivy has a risk profile that is both concentrated (13% in gold as of 9/30/11), and bullish (82% in global stocks), while Pimco is more defensive (bonds, TIPs, real estate, and commodities) and diversified (its largest holding last September was a 9% position in a bond fund). PAAIX owns a variety of PIMCO mutual funds, so there is some layering of fees that makes costs difficult to calculate. Personally, I’m not a fan of this approach, but PAAIX gets 5 stars from Morningstar.
The bottom line: Ivy and PIMCO both have solid track records despite radically different approaches. This can be confusing.
Apples and Oranges
Ivy and PIMCO not only take different roads to diversification, these funds have taken very different bets about the future. This type of variation makes it impossible to generalize about tactical funds. Therefore, Damato advises investors to ask a lot of questions, and take an active role in the evaluation of any tactical fund they consider. Tactical funds are best left to investors and advisors who understand their complexity, and I believe should be used as a satellite holding in retirement portfolios. Otherwise, an investor could be stuck with an asset allocation that is unsuitable for their goals, or completely out of whack when they need liquidity. For these reasons, tactical funds require special oversight.
Who Is NOT Suitable for Tactical Funds?
All of this oversight creates a lot of homework, and it is not always suitable for average investors. In fact, after reading the article, I identified two categories of investors who are not suitable for tactical funds:
1. Unsophisticated individual investors. These investors are unsuitable because they lack the expertise to evaluate tactical funds.
2. Sophisticated AND self-directed investors. These investors are unsuitable because since a self-directed investor could make their own asset allocation decisions using ETFs.
You could argue about the second category self-directed investors, since they might want to delegate asset allocation, just as some investors delegate stock selection. But evaluating tactical funds requires a quantum leap in sophistication. Moreover, there are well-established tools and benchmarks available to the average investor to evaluate a standard mutual fund. These same tools do not exist for tactical funds. What is the benchmark? What is the goal? Absolute returns or relative returns? What is the process by which to evaluate the fund manager? There are no answers yet to these questions, making this dangerous territory for the average investor.
I believe that these challenges make it incredibly challenging for self-directed investors to evaluate tactical funds. In addition, a self-directed investor would need their own view of asset allocation in order to disagree with the fund manager’s asset allocation. And if a self-directed investor has their own view of asset allocation, why wouldn’t they just execute their strategy themselves with ETFs and low-cost funds? This would be simpler, cheaper, more transparent, and more tax efficient. (In fact, I believe that ETFs will continue to revolutionize the wealth management industry, as I wrote on Seeking Alpha back in 2009.) All told, this seems like a lot of homework for a mutual fund.
Who Are Suitable Investors for Tactical Funds?
1. Sophisticated individual investors who are not self-directed
2. Investment advisors
A sophisticated individual investor may not be self-directed, and may wish to delegate asset allocation to a third-party portfolio manager (either a mutual fund or an investment advisor). A sophisticated investor may also want to bet on a given fund manager, simply because they like the manager’s thinking. This investor could buy a tactical fund for either purpose, though I wouldn’t recommend a tactical fund as a person’s core retirement vehicle.
Alternatively, tactical funds also make sense for an investment advisor with a wide range of clients. Advisors are also more likely to have fund screening and monitoring tools, and they are likely to be familiar with bullish and bearish scenarios (and how to execute them). For advisors, tactical funds are another tool in the toolbox.
The Role of an Advisor
As a registered investment advisor, I have to admit that I’m prone to see the benefits of professional advice: I believe that customization and direct interaction with clients are valuable services. Don’t get me wrong: I have no bone to pick with self-directed investors or DIY investing. But I do not think that individuals should delegate their core asset allocation decision to a mutual fund. Tactical funds tempt investors to do this, and they tempt investors to put primary emphasis on tactical allocation, and secondary emphasis on strategic allocation. By definition, a mutual fund does not customize, and it lacks interaction with the client to determine suitability. Granted, a mutual fund firm may offer screening when a fund is bought. But I am not aware of any process that evaluates the suitability of a mutual fund after purchase. Thus, the fund cannot monitor the goals of an investor, the outlook for capital markets, or the evolving state of financial product solutions.
The Misuse of Tactical Funds
As noted in the previous paragraph, I believe tactical funds tempt investors to neglect strategic asset allocation. Tactical funds are also prone to misuse for other reasons, beginning with investor expectations. Target-date funds offer a cautionary tale about unrealistic expectations.
When target-date funds (or life-cycle funds) were introduced to investors, the marketing materials emphasized how diversification could reduce risk. Target-date funds offered low-cost diversification based on Modern Portfolio Theory, and this was an improvement for many retirement portfolios.
Then came the bear market of 2008-2009, and investors were bitterly disappointed with performance. The funds did not say that they eliminated risk, they just said that they reduced risk. The problem was not one of execution, but of perception: Investor expectations were unreasonable.
Likewise, tactical funds today are marketed in ways that may lead to great expectations. If anything, tactical funds are even more prone to unreasonable expectations, since they give portfolio managers even more freedom to operate.
In addition, because tactical funds are so complex, they are also likely to ensnare investors who are unsuitable. The issue of suitability is always tricky, since mutual funds aggregate the risk tolerance and time horizons of thousands of investors. But when it comes to tactical funds, the potential for error is much greater, since the manager has much greater freedom than in traditional mutual fund categories. Investors may want such exotic fare when the manager is doing well, but the suitability of investors will truly be tested when a large tactical fund has a sustained period of terrible performance. This could occur due to either market conditions or manager decisions, but weak performance will spur investors to reconsider risk (see end notes for a discussion about how risk tolerance evolves).
Why Did Vanguard Abandon Tactical Funds?
The Wall Street Journal reported in Monday’s article that Vanguard is exiting tactical funds not just because of disappointing returns, but because of doubts about the strategy itself:
Francis Kinniry, a principal in Vanguard's investment-strategy group, says that when fund managers have very wide discretion on how to invest, "all you are doing there is increasing the distribution" of results—from big gains at the funds whose managers make astute shifts to big losses at those who blow it. That potential for wide variations relative to a benchmark is, "to us, much more risk for the average investor," he says.
In other words, Vanguard does not believe that tactical funds are in the best interests of the average client. Vanguard has historically been strongly committed to low costs and diversification, and tactical funds put less emphasis on these, and less emphasis on strategic asset allocation. Thus, tactical funds may encourage investors to take excessive risks in the quest for alpha, and to neglect the fundamentals of portfolio management.
I am speculating, but I believe Vanguard is also abandoning tactical funds because the product is not consistent with its core values. Vanguard realizes that tactical funds are like drugs: They are great when you use them according to the instructions, but they can be terrible when you go off-label. The average investor cannot tell when their use of a tactical fund is “off-label,” and they may be tempted to sue the mutual fund company if their expectations are not met. Thus, I believe that concerns about both suitability and investor expectations contributed to Vanguard’s decision.
Conclusion: Is Risk Tolerance Static?
Both target-date funds and tactical funds assume a certain risk level for their aggregate investor base. Target-date funds reduce risk over an investor’s lifetime by adding bonds, providing a “glide path” to retirement. (Unfortunately, it’s easier to see a crash landing instead of a glide path, given today’s low yields, rising inflation, and looming sovereign risk. But a higher allocation to bonds is inevitable for most target-date funds.)
As for tactical funds, there is a more subtle risk at work. Most investment models assume that risk tolerance is a static variable. In reality, an investor’s risk tolerance varies not only with age (becoming more conservative), but also with market volatility. As markets become more volatile, investors become more conservative. This presents a tricky proposition for tactical funds: When markets decline, investors want less risk, even though this might be the best time to buy.
My thanks to Armin Holzer for these insights.
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