Pro: tactical asset allocation: a sure-fire investment technique or just a fad?

Tactical asset allocation: a sure-fire investment technique or just a fad?

An investment strategy founded in fact

Tactical asset allocation has its share of disbelievers. But when the return it realizes is compared to that of comparable funds or the market's performance, TAA seems to win out. One expert says the evidence in favor of the asset investment strategy is convincing.

Tactical asset allocation was all the rage in 1988. As a result, nearly $40 billion in assets is now under the management of companies that pursue this investment strategy. And there is no end to this growth in sight.

Despite its increasingly widespread use, however, tactical asset allocation has its detractors. So any chief financial officer or treasurer weighing investment strategies in relation to pension or other corporate funds would be wise to understand the criticism, and the praise, being heaped on this strategy.

Strategic asset allocation, a familiar term, involves deciding how to invest one's funds among various asset classes, such as stocks, bonds, cash equivalents, and perhaps other kinds of investment instruments, in light of their long-term outlooks. Tactical asset allocation (TAA), on the other hand, involves making short-term adjustments in the asset mix because one of the asset classes becomes overvalued or undervalued in relation to other classes.

Sponsors and investment managers of institutional portfolios, as well as many individual investors, have come to understand that the decisions they make on how to invest among various asset classes is much more important than choosing individual stocks, bonds, or other securities. After all, the best equity manager in the world will have a difficult time if stocks as a whole behave poorly. And the best bond manager is not apt to do well if interest rates rise and bonds drop in price. In this regard, several studies show that at least 80 percent of the long-term returns of pension funds are due to how they allocate their money among various asset classes.

What, if anything, is wrong with this approach? The detractors of TAA make several charges: * It's just a fad.--Although it's true that TAA has increased markedly in popularity since the stock market crash in October of 1987, it actually has been in use since the early 1970s. It is hardly a new-fangled theory conceived to take advantage of the mistakes investors made prior to the crash. * It won't prove any more effective than portfolio insurance, which wasn't very good at all in protecting investors against the 1987 crash.--The fact is it has already proved more effective. The reason is simple. Portfolio insurance reacts to change. TAA anticipates it. * It's market timing under a new name.--Traditional market timing involves moving into and out of various securities markets on the basis of subjective forecasts of how these markets will change. TAA, however, is not market timing in the sense that the term is commonly used. Most TAA practitioners use a process that relies on currently available information and do not attempt to forecast future developments to judge the directions various markets will take. Instead, they concentrate on fact-based valuations of various asset classes and make their adjustments accordingly. * It's costly because TAA practitioners make frequent entrances into and exits from the various securities markets, thus incurring high transaction expenses.--This is not true. Using stock and bond index options and futures, or index funds, instead of stocks and bonds themselves makes market entrances and exits efficient and comparatively inexpensive. * It's a product created to make use of the powerful computers many companies now own.--This isn't true either. Although computers do make number-crunching easier, the data that TAA requires could be analyzed with the help of a hand calculator. * It will become too popular, and neither the cash nor futures markets will be able to accommodate all the transactions needed. Besides, say detractors, investors will come to anticipate the signals thrown off by TAA computer models and take counteraction that will limit the strategy's value.--All this seems unlikely. Many investment committees prefer an active investment strategy to the largely passive strategy most TAA practitioners employ. They don't want to seem to delegate their investment responsibility to a strategy that runs largely on automatic pilot. In the last example of the misconceptions about TAA, it is interesting to note that some investment committees that initially committed to TAA found they couldn't refrain from tinkering with the strategy or second-guessing it. This proved especially true during the first nine months of 1987, when TAA services were recommending steady reductions in equity holdings because stocks were overvalued in relation to other assets. Meanwhile, of course, investors who held stocks were making a great deal of money. Unfortunately, most of these investors still owned their stocks when the market fell, and they suffered substantial losses.

By contrast, almost all tactical asset allocators were largely out of the stock market on Black Monday. Indeed, most of these allocators have done very well over the years by adjusting to changes in the valuations of various asset classes. Certainly, they have done better than many investment managers using conventional strategies.

What's wrong with conventional wisdom?

Conventional investment managers make their asset allocation decisions after studying, among other things, data on the business, economic, and monetary cycles. Unfortunately, this approach doesn't work on a consistent basis.

The reason is that these managers tend to get caught up in a group consensus on which way the various securities markets are headed. This consensus seems very appealing because so many people seem to be thinking the same thing. Yet group-think is usually subjective and often wrong. Thus, in the months prior to October of 1987, many investment managers rationalized the unrelenting rise in equity prices and failed to reduce their equity holdings or recommend that others do so.

Another reason that conventional investment strategies often don't work is that they concentrate on the short term. Yet it's usually much harder to predict what a given securities market will do in the next month or the next quarter than perceive what it will do over the next few years.

For one thing, the short term can be very volatile. For another, there is a wealth of historical data available on capital market theory and on the various securities markets and their relationships to each other over long periods of time. This information helps tactical asset allocators study the long-term outlook for various asset classes, which is what they concentrate on anyway, and recommend shifts when current valuations deviate from that outlook.

The principles behind TAA are easy to understand. Each asset class is analyzed as to its expected total return relative to the returns from other asset classes. This analysis enables investors to find and purchase undervalued asset classes and avoid or sell fully valued or overvalued asset classes. It is another way of following the time-honored concept of buying low and selling high.

Measuring the relative valuations of asset classes is not hard. There are, of course, various asset allocation models. Some are fed data on such things as inflationary expectations, technical analysis, and "investor sentiment." But many employ only objective data.

For well over a decade one of the country's most widely used valuation techniques has been one created by Vestek Systems of San Francisco. This technique employs a so-called spread approach that compares the expected returns from different securities markets and recommends investment decisions accordingly.

The proxy for the bond market is the yield to maturity on 20-year bonds, and the proxy for cash equivalents is the yield on three-month U.S. Treasury bills. (Other asset allocation services may use somewhat different maturities.) The proxy for stocks is a dividend discount model that derives the expected return for the stock market from the stocks' estimated future dividend flow and from the current level of stock prices as reflected by the S&P 500.

Stock market valuations and bond and cash-equivalent yields are available daily. And several investment services estimate the future dividend flow from stocks every week.

Often tactical asset allocation services factor the past volatility of various asset classes and the correlations between these classes--i.e., how closely one moves in relation to others--into their recommendations. Even so, the spreads between the expected returns from the classes are the most important figures, especially the spread between stocks and bonds.

These spreads provide significant indicators of the future direction of the securities markets. Thus Vestek has been calculating the spreads between the markets since 1975. The results show that at times the spread favored stocks by 600 basis points or more, particularly in 1980, which turned out to be the best year for the stock market in more than a decade. By contrast, the spread favoring stocks plunged to 40 basis points in--you guessed it--October of 1987.

It surveys the performance of the stock, bond, and cash-equivalent markets from 1975 through September of 1988. More important, it shows what an investor could have achieved by shifting its funds among the various asset classes as Vestek recommended and investing in representative market indexes, such as the S&P 500.

How did TAA rate?

First, both the unrestricted and restricted funds that use tactical asset allocation techniques outperformed the stock, bond, and cash-equivalent markets over sustained periods of time--three, five, and 10 years. Indeed, the funds usually won by substantial margins.

Second, the unrestricted funds also surpassed the restricted funds over sustained periods of time. The reason was that stocks did spectacularly well in some years, and the unrestricted funds were able to shift more of their holdings into equities during these periods.

Third, the constant-mix funds did not do as well as either the unrestricted or restricted fund over the three-, five-, and 10-year periods. Yet they did better than either the bond or cash-equivalent markets, although not as well as the stock market.

The most significant findings, however, relate to the performance of the three tactical asset allocation funds in relation to the balanced funds reported on in the chart's last three columns. As you can see, the unrestricted funds did consistently better than even the best of the balanced funds over lengthy periods of time. The restricted funds did not do quite as well over the three-and five-year periods, but more than a percentage point better over 10 years. And the constant-mix funds lagged the best of the balanced funds in all three time periods. Note, though, that all three kinds of TAA funds vested the median balanced funds, often by sizable margins.

The evidence, then, is plain: The use of tactical asset allocation can and does enable investors to outperform both the overall markets and comparable balanced funds that are actively rather than passively managed. TAA can do this because it provides a very credible, systematic, fact-based approach to investing and avoids the emotional biases inherent in forecasting the various markets.

TAA is not perfect, of course. But it has significant predictive accuracy. And it certainly has enabled managers who use it to outperform many of their activist competitors. The latter often do not live up to expectations, and they also incur higher management and transaction costs. Chief financial officers, take note.