The past two years have been difficult ones for tactical asset allocation (TAA). The continual V shaped corrections and a lack of trend in any asset class has caused TAA strategies to lag the US market. On the plus side, TAA strategies have outperformed global asset classes and since we are probably closer to the top of the market than the bottom we are probably very close to a point where TAA will really show its value when we hit a bear market. Any investment strategy will have a market environment it doesn’t work as well in. For traditional asset allocation it is a bear market and markets where most asset classes are not doing well. For TAA it is a choppy market. I would much rather talk to clients about underperformance in a choppy market than try to justify being down 30% while the market is down 40%. Putting all that aside we need to consider some important issues about the past two years as it relates to the future of TAA.
The questions that practioners should be asking now are:
1. Is the choppiness of the past couple of years a fluke that is not likely to persist
2. Is the choppiness of the past couple of years the “new normal”
The answer to both of those questions is probably no, but we need to be better prepared for years like this. In thinking through this problem a number of important thoughts come to mind.
1. We need to take backtests with a grain of salt. We can do walk forward testing, 3D analysis, etc to make sure we are not curve fitting but any long term backtest that shows great results doesn’t have a lot of relevance in today’s markets. On the flip side, any backtest that handles these markets and struggles in trending markets is just curve fitting and also doomed to failure. Backtesting systems is still important but we need to apply a lot of forward looking common sense.
2. All in or all out models might not be optimal. Traditionally, TAA models were all in or all out. For example, a system that bought the S&P 500 when it is above its 200 day moving average would move 100% of its portfolio to stocks or cash on one fixed day a month. That works fine when you have strong trends but fails miserably in a choppy market.
3. Rebalance date risk must be taken into account. In the example above the moving average system would rebalance on one fixed day. Sometimes it will be a perfect day to rebalance, other times it won’t. Over time this should even out, but in a choppy market with large moves missing something by a day or two can be devastating.
4. TAA strategies need to include multiple methodologies. In a trending market just about everything works all the time. In a choppy market different methodologies will cycle in and out of favor. Just like asset allocators diversify by asset class, TAA practioners need to diversify by tactical methodology. Just like Modern Portfolio Theory (MPT) optimizes asset classes, TAA can optimize tactical methodologies. With MPT asset classes that could never stand alone in a portfolio can be a strong part of a diversified portfolio. The same approach can work with TAA, methodologies that might not be ideal for an entire portfolio can be part of a well balanced strategy.
5. TAA strategies need to include some sort of counter trend methodology. A TAA strategy is never going to be nimble enough to turn on a dime in a V shaped recovery, momentum and trend following models take time to move from safe havens back into the market. Counter trend methodologies have no such limitations and can get in at short term market bottoms and out at short term market tops. Having these methodologies as part of a TAA strategy will allow the portfolio to get invested once a recovery has started.
We can either put our heads in the sand and hope that the choppiness of the past couple of years is just a fluke or we can adapt our models so that they not only work in trending markets but they can also do fine in a choppy market.