What is tactical asset allocation?
Tactical asset allocation is an investment strategy that blends elements of passive and active management in an effort to produce superior risk-adjusted returns. ArcPoint specializes in constructing portfolios of low-cost index stock and bond funds. The individual funds are passively managed to track a given index, but ArcPoint actively adjusts the allocations to these funds to take advantage of changing performance expectations.
Why it works.
The key to any successful investment strategy is that a range of longer-term performance outcomes can be estimated with some degree of confidence. The passive vs. active management debate centers on the belief in the ability of investors to construct such strategies. Many investors have been led to believe that markets are highly efficient, such that any type of active management is unlikely to produce superior returns. But the analysis that supports this conclusion tends to focus on the performance of actively managed stock funds vs. an index like the S&P 500. Choosing among individual stocks or bonds from a single index is a much different exercise than choosing between groups of stocks or bonds from different indices. The expected return for a broad group of securities within an asset class can be estimated with much greater confidence than the return for an individual security. For example, the value of any stock (or equity) is the discounted value of future estimated payments to shareholders in the form of dividends or share repurchases:
Teasing out the expected stock return (“required equity return” in the above equation) implied by the current stock price requires estimates for future earnings, returns on reinvested earnings and payout ratios. This is a difficult task, especially since many companies are at different stages of maturity and are practically impossible to fit into this theoretical model (e.g., Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN) or Google (NASDAQ:GOOG) (NASDAQ:GOOGL)).
However, our task become simpler when we aggregate hundreds of companies and trillions of dollars of invested capital together. The larger the aggregate amount of invested capital and greater the diversity of companies and industries represented in the asset class, the more likely the average return on reinvested earnings is equal to the average required return to equity capital implied by market prices. If the average return on reinvested earnings and required return to equity are the same, the expected return for the asset class simplifies to the earnings yield of the asset class, or the ratio of next period earnings to equity value:
Now we only need to estimate a single variable (next year’s earnings) for our group of companies in order to come up with an expected (or “required”) return. And because we are making estimates for the several hundred companies in each asset class, many of the errors inherent in any estimation process will cancel each other out. Our earnings estimates will prove to be too high for some companies and too low for others, but in aggregate should reflect a reasonable estimate for each class of stock.
Expected returns for groups of bonds also can be derived by using current market prices to estimate implied future returns for a range of maturities and credit qualities. Once we come up with expected return forecasts for different groups of stocks and bonds, we can determine the appropriate mix that maximizes the expected portfolio return for a specified level of risk.
Investors with above average risk tolerance likely have the most to gain from a tactical approach.
We have back-tested ArcPoint’s tactical asset allocation approach over the past 10 years. For each level of specified portfolio risk, we compared the annualized returns of two portfolios comprised of the lowest cost funds (including ETFs) available at each date. The first portfolio was reallocated at the end of each month to match the optimal mix based upon our return outlook for each asset class at that date. The second portfolio was rebalanced monthly to a static asset allocation that reflected the average holdings of the first portfolio over the 10-year period examined.
Tactical vs. Static Asset Allocation Annualized Returns
Source: ArcPoint Advisor. Data through 10/31/2017.
The data from our backtest suggests that the greatest benefits of tactical asset allocation are likely to accrue to investors with above average risk tolerance that have a higher allocation to stocks. Investors at the 75th and 90th percentile of risk tolerance (from our proprietary database of investor behavior) should have had 72% and 87% of their portfolios in stocks, on average, over the period examined. For these investors, the tactical portfolio outperformed the static portfolio over all measured periods. And over the past 10 years, the tactical approach added more than 40bp a year to their return.
For investors with average or below average risk tolerance, the tactical portfolios outperformed over the past 10 years, but underperformed over the past three and five years. The stock allocation of these portfolios averaged 39% to 54% over the past 10 years. The smaller average allocation to stocks within these portfolios somewhat restricts the ability of our tactical approach to adjust to sharp swings in expectations for stock returns.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.