Tactical Asset Allocation (TAA): a tool for the individual investor.
Tactical Asset Allocation (TAA) is an active portfolio management strategy that is growing in popularity with institutional investors. In 1988, over $20 billion in pension and mutual funds were being managed according to TAA guidelines, and that amount is increasing daily . Some recent estimates place the current figure at $40 billion . But what is TAA, and is it an appropriate strategy for individuals? This article defines TAA, explains why it is suddenly so popular, and gauges its potential for success from an individual's point of view.
TAA and Alternative Strategies
Almost all portfolio management strategies are actually variations of three primary tactics. The first is a passive approach in which the investor simply buys a portfolio of securities and holds it; hence, it is often called a "buy-and-hold" strategy. The portfolio may consist of stocks, bonds, commodities, money market instruments, or any combination of these security classes. The proportion of funds invested in each type of security determines both the expected return and risk of the portfolio. The choice of security classes and their proportions is known as the asset allocation mix. Any alternative to the buy-and-hold strategy must produce either higher returns for the same level of risk or lower risk for the same level of returns before it can be declared superior.
The second portfolio management approach is the use of either fundamental or technical analysis to identify and select undervalued securities. This active portfolio management approach, often called a "security-selection" strategy, requires considerable time, effort, and expense in the analysis of individual securities. The composition of the portfolio usually changes very frequently, which causes high transactions costs. Most studies, such as that of Brinson, Hood, and Beebower, indicate that the security-selection approach is not superior to the buy-and-hold strategy . Reilly provides a good review of this issue within the context of market efficiency [8, pp. 212-249].
The third tactic is TAA. Using TAA, an asset allocation mix is chosen, but it is allowed to vary over time depending on market conditions. Most TAA strategies require some minimum investment in each security class. In one variation, a pure "market-timing" strategy, the minimum investment in equity securities may be zero . In this approach, the investor forecasts the performance of the stock market relative to the available return on Treasury bills (T-bills). If the market return is predicted to be higher than the return on T-bills, funds are invested in stocks; otherwise, funds are invested in T-bills. The forecast is updated at regular intervals and funds are allocated on the basis of the predicted market return. Is TAA superior to a buy-and-hold strategy? That question is addressed in the next section.
An Analysis of TAA
Professor William F. Sharpe of Stanford University conducted the first and most often cited test of market timing . He first calculated the annual rate of return an investor would have earned if funds had been invested in stocks in 1934 and held until 1972; he also calculated the risk of this buy-and-hold strategy, as measured by the standard deviation of annual returns.
Sharpe then assumed that at the beginning of each year an investor would make a forecast about the expected direction of the stock market. Based on this forecast, the investor would buy either stocks or T-bills. Sharpe assumed that a transactions cost of two percent was incurred each time the investor switched from one security to the other. If the investor had perfect predictive ability, then this market-timing strategy had both higher return and lower risk relative to the simple buy-and-hold strategy. If the investor was right only half the time, the market-timing strategy still had lower risk, but it also had a much lower return. In fact, a predictive accuracy of over 81 percent was required for the market-timing strategy to have a higher return than a buy-and-hold strategy.
T-bill returns are less volatile than stock returns. Since the market-timing strategy often requires an investment in T-bills instead of in stocks, this strategy results in a standard deviation of returns lower than that of a buy-and-hold portfolio of stocks. Sharpe recognized that a comparison of returns between the two approaches would be meaningful only if the risks were equivalent. To solve this problem, he modified the buy-and-hold strategy. Instead of buying only stocks at the beginning of the study period, the investor bought and held a portfolio containing a mixture of stocks and T-bills. It was still a buy-and-hold strategy, but this mixed portfolio had less risk (and also less return) than the previous portfolio containing only stocks. An accuracy of 73 percent was required for the market-timing strategy to have a higher return than the equivalent-risk buy-and-hold portfolio.
Given such a high requirement for predictive accuracy, it seems as though a market-timing strategy is doomed to failure. Why then is TAA now one of the hottest techniques used by institutional investors? Was Sharpe's study wrong or are institutional investors throwing away money? The answer to both questions is no. To understand this answer, it is necessary to look at the market environment.
The market environment during Sharpe's study period (1934-1972) was significantly different from the more recent market environment. Table 1 on page 10 highlights some of the differences. Notice that over 67 percent of the years during Sharpe's study period had stock market returns higher than T-bill rates. In contrast, only 60 percent of the years in a recent period (1966-1985) had market returns higher than T-bill rates. During this 20 year period, average market returns were slightly lower than in Sharpe's study period, but average T-bill rates were much higher. Ehrhardt replicated portions of Sharpe's study and showed that during the period 1966-1985 a predictive accuracy of only 62 percent was required for TAA to outperform the equivalent-risk buy-and-hold strategy .
Table : Table 1
The Changing Investment Environment 1934-1972 1966-1985 (%) (%) Years in 67 60
Which Stocks Out-Performed
Average Annual Stock 12.76 10.35
Average Annual T-bill 2.40 7.33
Two of Sharpe's original assumptions are probably no longer representative of the current market environment: (1) institutions make portfolio revisions more frequently than once a year, and (2) institutional transactions costs are much less than two percent. Ehrhardt updated the Sharpe study to reflect more frequent revisions (quarterly and monthly) and smaller transactions costs . He found that if portfolio revisions are conducted on a monthly basis and a realistic institutional transactions cost of 0.25 percent is incurred, then a predictive accuracy of only 55 percent is needed to outperform the equivalent-risk buy-and-hold strategy. It is no wonder that TAA excites institutional investors, but what is the potential for individuals?
When it comes to transactions costs, individual investors are at a distinct disadvantage. Institutions often make direct trades with one another, bypassing the conventional stock exchanges. Individuals, however, must trade through a broker. Even discount brokers charge between one and two percent in commissions, a substantially higher transactions cost than that faced by institutions. Table 2 on page 11 shows the impact of increasing transactions costs on required predictive accuracy. At a realistic transactions cost rate of 1.5 percent per trade for an individual, the required predictive accuracy is 74 percent, a level that is probably not achievable.
Table : Table 2
Transactions Costs and Required Predictive Accuracy for TAA to Out-Perform a Buy-and-Hold Strategy (Monthly Portfolio Revision, 1966-1985) Required Predictive Transactions Costs Accuracy (%) (%) 0.25 55 1.00 66 1.50 74 2.00 80
And additional disadvantage for individuals investing directly in securities is the lack of adequate diversification. An institution can directly invest in hundreds of securities, something that is impossible for most individuals.
In fact, transactions costs and the lack of diversification not only impede the direct implementation of TAA for individuals, but also discourage many individuals from investing directly in the stock market at all. Many choose, however, to invest in the stock market indirectly through mutual funds. It is the existence of mutual funds that also makes the implementation of TAA possible for small investors. Because of their importance, a brief discussion of mutual funds follows. For a more thorough discussion of mutual funds, see Reilly and the American Association of Individual Investors [1, pp. 1-54;8,p. 834-865].
Many mutual investment firms offer a "family of mutual funds" to investors. Typical "members of the family" might be funds that invest in stocks with high dividend payouts, stocks with low dividends but high growth (capital gains) prospects, and/or combinations of high dividend paying stocks and corporate bonds. Some funds invest only in firms from specific industries, like energy or high technology. Other funds invest in commodities like gold (through stock ownership of gold mining firms), while still others invest in international stocks. Some invest only in long term corporate bonds or tax exempt municipal bonds. These are only examples; the variety of available funds is quite extensive.
Many firms offer "no-load" funds, meaning that no fees are charged to the investors when money is either invested or withdrawn from the fund. Most such firms allow their clients to switch investments among the various funds that they operate. Many allow transactions to be executed over the phone, although the transaction for an order usually takes place at the closing price, even if the order is placed in the morning.
Almost all firms providing a family of funds offer a money market fund, which contains short term, low risk instrument like T-bills. Many firms also offer an index fund. An index fund's portfolio matches that of a broad based market index such as the Standard and Poor's (S&P) 500 Index, and thus, its performance closely matches that of the market as a whole. With these two funds, it is possible for an investor to easily invest in the "market" or in T-bills.
The Potential for Individuals
Only a few changes in Sharpe's methodology are required to evaluate TAA from an individual's perspective . The returns for stocks and T-bills must be reduced by the management fees charged by the mutual fund. According to the American Association of Individual Investors, the average management fee for no-load funds is about 1.25 percent . No cost is incurred by the individual for any specific transaction, since this is already reflected in the management fee. Notice that the individual pays for the switching privilege, whether or not it is used.
Selected predictive accuracies and the incremental returns for TAA versus the equivalent-risk buy-and-hold strategy are provided in Table 3 on page 12. These assume monthly revisions, a 1.25 percent annual management fee, and are for the period 1966-1985.
An investor with no forecasting skill (a predictive accuracy of 50 percent) would have lost about 0.59 percent per year relative to a buy-and-hold policy. An individual with a predictive accuracy of only 52 percent would have profited with TAA, although the extra return of 0.25 percent per year is quite small. As accuracy increases, so does the extra profit. A predictive accuracy of 56 percent would have yielded over 1.94 percent per year relative to a buy-and-hold strategy, while an accuracy of 64 percent would have provided an extra 5.40 percent per year.
These figures are for the incremental returns of TAA versus the equivalent-risk buy-and-hold portfolio. When comparing TAA with an all stock buy-and-hold portfolio, the required prediction accuracy is still only 52 percent. As prediction accuracy increases, the incremental profits also increase, although they are slightly smaller than when the comparison is made with the equivalent-risk buy-and-hold portfolio. Not all mutual funds have management expenses of 1.25 percent per year; in fact, the expenses are likely to differ among stock funds, bond funds, index funds, and money market funds. The previous tests were repeated for several different levels of management expense; the results were virtually unchanged. Complete details are available from the authors.
Table : Table 3
Required Predictive Accuracy and Incremental Return for TAA versus Buy-and-Hold (1966-1985) Required Predictive Incremental Returns Accuracy Monthly Annually(a) % % % 50 -0.05 -0.59 52 0.02 0.25 54 0.09 1.09 56 0.16 1.94 58 0.23 2.80 60 0.30 3.66 62 0.37 4.52 64 0.44 5.40
(a) Rate compounded monthly
for the Individual
There are several reasons why it is probably not prudent for an individual to manage all investments with a pure market-timing strategy. One of the differences between pure market timing and TAA is in the amount that is switched. Rather than all or nothing, most institutional TAA policies require a minimum level of investments in stocks and T-bills at all times . In addition, adequate diversification in a global economy requires spreading investments over more than just domestic stocks and T-bills. Finally, this study has shown that TAA could have been successfully implemented in a recent 20 year period, but that is no guarantee that it will be successful in the next 20 years. For these reasons, the following investment policies for an individual are suggested.
First, the individual should divide the amount to be invested into two components: a permanent component and a component to be managed by TAA. The permanent component should contain a wide array of securities. These should include:
* Stocks, both domestic and international * Bonds, both corporate and government * Commodities, such as gold, silver, and real
estate * Money market instruments, such as T-bills,
commercial paper, and certificates of deposit.
The proportion invested in the permanent component and the choice of the asset allocation mix depends on the investor's level of acceptable risk . These choices are typically reviewed on an annual basis.
The investments in the permanent component can be made through individual mutual funds for each asset class, although there is a less complicated alternative. Some mutual investment firms now offer a permanent investment fund that contains many of these assets in one fund . Thus, it is possible to invest directly in a permanent portfolio.
To implement TAA for the second component, the individual should select an appropriate mutual investment company. In particular, the company should have:
* No-load funds * Telephone switching and redemption privileges * Low management expenses * A proven track record * A money market fund * A stock index fund.
An index fund mirrors the entire market, making it a natural choice for TAA. With an index fund as the stock component, only the direction of the overall market needs to be forecasted. In addition, the fund is by definition well diversified and management expenses are much lower than those of an actively managed mutual fund. There are many guides to help the individual choose a fund, such as the one produced annually by the American Association of Individual Investors .
TAA may also be implemented through an individual's pension plan, since many plans have provisions similar to those described for mutual funds. For example, TIAA/CREF (Teacher's Insurance and Annuity Association and College Retirement Equity Fund) permits the individual to switch money among a stock fund, a bond fund, and a money market fund. The transactions are authorized over the telephone, any percentage may be switched, and the transactions may be conducted on a daily basis.
The last step required in implementing TAA is for the individual to develop some method for forecasting whether the expected stock market return will be higher than the observable T-bill rate. Institutional investors use powerful computers and sophisticated econometric models that include "industrial production, inflation, short and long term interest rates, and stock prices and dividends" as variables .
Fortunately for the individual, there are easier approaches that may be effective. For example, Remaley demonstrated that a simple moving average can be used to predict market turning points . Remaley also showed how monitoring Federal Reserve policy may be used to time the market . In addition, there are many publications, television shows, and radio programs that provide financial forecasts. In the final analysis, it is the individual's judgement that makes the difference.
Given a forecast, however it is determined, the investment should be in the index fund if stocks are predicted to outperform T-bills; otherwise, the investment should be in the money market fund. A review of market conditions should be conducted on a monthly basis or more frequently if the market is exceptionally volatile.
Tactical Asset Allocation is one of the hottest topics on Wall Street, but it is not just for the institutional money manager. With reasonable forecasting ability and access to a family of mutual funds, the individual also can profit from this trading strategy.
[1.] American Association of Individual Investors (AAII). The Individual Investor's Guide to No-Load Mutual Funds. 1988 Edition, p. 12.
[2.] Brinson, G.P., L.R. Hood, and G.L. Beebower. "Determinants of Portfolio Performance." Financial Analysts Journal, Vol. 42, No. 4, July/August 1986, pp. 39-44.
[3.] Ehrhardt, M.C. "The Predictive Accuracy Required When Investing Through Tactical Asset Allocation." American Business Review, Vol. 8, No. 1, January 1990, pp. 8-15.
[4.] Fuller, R.J. and J.L. Farrell, Jr. Modern Investments and Security Analysis. New York: McGraw-Hill Book Company, 1987, pp. 537-558.
[5.] Laderman, J.M. "Welcome to the New Money Game." Business Week, May 30, 1988, p. 88.
[6.] Nathans, L. "Allocating Your Assets: You May Not Need a Pro." Business Week, May 8, 1989, pp. 152-153.
[7.] Phillips, D. and J. Lee. "Differentiating Tactical Asset Allocation from Market Timing." Financial Analysts Journal, Vol. 45, No. 2, March/ April 1989, pp. 14-16.
[8.] Reilly, F.K. Investment Analysis and Portfolio Management, 2nd edition. New York: CBS College Publishing, 1985, pp. 163-204 and pp. 833-860.
[9.] Remaley, W.A. "Moving Averages and Market Timing." AAII Journal, Vol. 9, No. 9, October 1987, pp. 11-14.
[10.] -. "A Synthesis: Priming the 200-Day Moving Average." AAII Journal, Vol. 11, No. 7, July 1989, pp. 13-17.
[11.] Sharpe, W.F. "Likely Gains from Market Timing." Financial Analysts Journal, Vol. 31, No. 2, March/April 1975, pp. 60-69.
[12.] Wallace, A.C. "Market Place: Computer Driven Shifts in Assets." The New York Times, June 28, 1989, p. 30.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||portfolio management strategy|
|Author:||Ehrhardt, Michael C.; Wachowicz, John M., Jr.|
|Publication:||Review of Business|
|Date:||Dec 22, 1990|
|Previous Article:||The quality process: little things mean a lot.|
|Next Article:||Futures versus swaps: some considerations for the thrift industry.|
|Pro: tactical asset allocation: a sure-fire investment technique or just a fad?|
|Con: tactical asset allocation: a sure-fire investment technique or just a fad?|