Dumb Alpha: Tactical Errors

by: CFA Institute Contributors

Originally published on December 5, 2016

By Joachim Klement, CFA

I recommended that investors "avoid the temptation to continuously tweak and tinker with their portfolio" in my previous Dumb Alpha piece. In response, some countered that staying close to the market is vital in today's volatile and unpredictable economy.

At the risk of alienating my readers, I feel I should clarify my thoughts on this issue.

Reinventing The Tactical Wheel

As the move toward indexing has accelerated, money managers have sought new ways to provide added value to investors - and to charge higher fees. One such technique is tactical asset allocation. This practice attempts to exploit short-term market opportunities to enhance the returns - or reduce the risks - of an existing portfolio. In a world full of geopolitical surprises, flash crashes, and other market disturbances, it seems reasonable to try to avoid the negative effects of such events and profit from the opportunities they might offer.

To be clear, this tactical investment technique is different from stock picking. Traditional stock pickers identify potentially undervalued securities and buy them for the long term. Tactical allocators buy securities at an opportune moment only to sell them shortly thereafter, when they have - presumably - increased in price. In other words, tactical asset allocation is another way of saying market timing.

What's The Track Record, Really?

While it sounds good in theory, the track record of market timers is even worse than that of stock pickers.

Many studies show that the majority of actively-managed funds underperform passive funds. Digging deeper, Luke F. Delorme recently checked the performance of tactical allocation funds as a sub-group of actively managed funds. He identified 57 tactical allocation funds and compared their performance over the last five years to the Vanguard Balanced Index Fund. Over both a three- and five-year horizon, not a single one outperformed. Indeed, the average underperformance was 5%-6% per year.

Longer track records of 10 and 15 years didn't show any improvement. No matter how far back Delorme looked, he couldn't find a single fund that outperformed the static Vanguard fund.

The last five to 15 years have been marked by some of the most extreme market setbacks and recoveries in decades. But in what should have been a good environment for tactical funds, their performance was among the worst I have ever seen.

Sauce Béarnaise Syndrome

Having been involved in tactical asset allocation for many years, I think an underestimated danger of tactical asset allocation is sauce béarnaise syndrome. What is this? Psychologist Martin Seligman ate béarnaise sauce while suffering from the flu. Shortly afterward, his body revolted and he experienced an extreme bout of nausea. This led to a lifelong aversion to béarnaise sauce. The trigger for Seligman's unpleasant night was the flu, but his body associated the symptoms with the sauce and he never ate it again.

By keeping a close watch on the market and engaging in tactical trades, investors will inevitably make moves that lose money. Even though their reasoning might have been correct, a losing trade may create a type of sauce béarnaise syndrome, leading investors to avoid similar investments in the future.

This conditioned taste aversion has been documented by Richard Thaler and Eric Johnson. The more frequently investors try to engage in the market, the more likely they will experience losses, and the more likely it is that they will develop an aversion to whatever their personal béarnaise sauce might be.

Every investment decision tends to reinforce our pre-existing biases on specific investments. Confirmation bias, recency bias, among others, taint investment decisions and destroy performance in the long run. Being close to the market increases their influence on a portfolio.

Tactical Allocation The Dumb Alpha Way

Since this is a post about Dumb Alpha techniques, I can't close on such a pessimistic note. If investors want to engage in tactical asset allocation, what would be the Dumb Alpha method of doing so?

Mebane Faber tested a simple quantitative approach to tactical asset allocation: If an asset is above its 200-day moving average, buy it, and if it drops below, sell it. Faber regularly updates the results of this study, but for our purposes, I calculated the performance of a simple tactical allocation fund designed the following way: If the S&P 500 index is above its 200-day moving average, the fund invests 60% in the S&P 500 stock index and 40% in the Barclays Global Aggregate Bond Index.

If the S&P 500 drops below its 200-day moving average, the allocation to stocks is reduced to 40% and the assets shifted into bonds. Transaction costs for each shift are assumed to be 0.2% of total portfolio assets (or 1% of the value of the assets sold).

Even with these high transaction costs, this simple tactical allocation fund outperformed the Vanguard Balanced Index fund by 0.6% per annum during the last five years, and by 1.5% per year over the last 10 to 15 years. And this performance could have been achieved in practice because the required sub-funds tracking these indices are available at extremely low costs from different providers.

The difference between the Dumb Alpha tactical allocation fund and the real-life tactical allocation funds has been in the order of 5% to 7% per year for the last five to 15 years. This is due partly to higher fees, but for the most part it is a result of the behavior gap that occurs when investors are too close to the market. And we are talking about professional fund managers.

This shows once again that everybody is subject to behavioral biases and bad investment decision-making. One of the best sources of alpha is to understand these biases and adapt your investment processes accordingly.

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