Tactical Allocation Funds Prove Market Timing Is Just Market Hype

by: Prateek Mehrotra

Summary

Tactical allocation mutual funds charge high fees but fail to provide better risk-adjusted returns or more downside protection.

Investors are better off maintaining a pre-set asset-allocation strategy and rebalancing their holdings periodically.

Investors would be better off diversifying the core of their portfolios across uncorrelated asset classes such as commodities, bonds, real estate, U.S. and foreign stocks.

The popularity of tactical allocation mutual funds has skyrocketed even though their average performance has failed to live up to the marketing hype. Wall Street firms providing tactical funds aim to maximize risk-adjusted returns with lower volatility by using proprietary economic and technical indicators to time the market. They try to beat the stock market by going where they think the puck is headed and varying their exposure to stocks and bonds accordingly. Instead, they have generally proven that their market-timing techniques leave much to be desired and that investors are better off maintaining a pre-set asset-allocation strategy and rebalancing their holdings periodically.

According to Morningstar, Tactical funds gained 1% year to date while returning 6% in the trailing year (through October 9). The category severely underperformed the benchmark SPDR S&P 500 ETF (NYSEARCA:SPY), which gained 6% and 19% over the same periods. Over the longer-term, tactical funds returned an average of 8% and 7% annually over the past three and five years. That pales in comparison to the S&P's annual returns of 21% and 15% over the same periods, according to Morningstar.

Tactical funds' long-term performance would be even worse, if the average included the ones that closed or merged with another fund because of poor performance. Morningstar currently counts 348 funds in the fund category, up from merely eight in 2007. Most of them are less than three years old. Only about a third of them have a five-year track record. All the while net inflows into tactical allocation funds reached nearly $19.4 billion over the past 10 years, according to Morningstar.

Tactical funds have also underperformed classically balanced funds. Morningstar's moderate allocation funds category -- the most popular among allocation funds -- returned 3% year to date and 9% in the past year (through October 9). They rose 12% and 9% annually over the past three and five years, respectively. They typically have a mix of 50% to 70% in stocks and the rest in bonds or cash.

Only 10 tactical allocation funds, according to Morningstar, have managed to beat moderate allocation funds on a five-year basis, and not a single one has beaten the S&P over that time period. To add insult to injury, tactical funds charge exorbitant management fees and have high turnover. Tactical funds on average charge an annual management fee of 1.48% as of 2014, according to Morningstar. That's nearly double the mutual fund industry average of 0.77%, according to ICI. On top of that, many charge a sales load of 5% or more.

Their five-year, upside-capture ratio of 85 indicates they only score 85% of the gains when the stock market advances, according to Morningstar. But their downside-capture ratio of nearly 102 means they sink slightly more during corrections. Their failure to offer better risk-adjusted returns or more downside protection reveals they're just another mouse trap for Wall Street firms to charge higher fees.

Instead of trying to time the market, investors would be better served to diversify the core of their portfolios across uncorrelated asset classes such as commodities, bonds and real estate in addition to holding both U.S. and foreign stocks. Investors should focus on controlling the amount of money they have at risk and the types of risks they take while limiting fees and taxes.

Does this mean tactical strategies should not be considered by investors? Absolutely not. Tactical funds can then be best used as satellite investments at the perimeter of the portfolio to help improve returns from their diversified core. Remember, that diversifying your core first will add more value over the longer term than picking the best performing tactical satellite investment.

Investors should ask key questions while conducting their due diligence on their tactical managers. Track record, the soundness and proprietary nature of their strategy, the frequency of the trading methodology, the experience of the management team, is it run by a black box and other critical factors should be examined by an investor prior to selecting a tactical manager. Tactical managers need to be monitored more closely in case their investing style falls out of favor, or perhaps their "edge" may no longer be effective in today's market.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.