That’s right folks, the Yinzer Analyst is back and this time, it’s personal. You know it’d have to be to drag me away from sprucing up the lawn and my Friday afternoon tallboys and well, with me it’s almost always personal since I do this for pleasure and not currency, but today I intend to discuss a recent article that appeared at Morningstar.com. Did they insult my mother or the Buffalo Bills? No, what really grinds my gears is when someone writes an article that I feel doesn’t tell the whole story, this time on Morningstar’s tactical allocation category.
The article in question was John Rekenthaler’s weekly commentary, based on an earlier piece by Luke Delorme at Advisor Prespectives (here), where on August 30th he took the funds in Morningstar’s tactical allocation category to ask for offering the worst of both worlds. And it’s not the he said anything wrong, in fact his advice to readers was perfect….if this was still 2011. But it’s been a long five years and the story has changed and maybe it’s time to reconsider our attitudes on tactical allocation as well.
Coming out of a deep downturn where they take heavy losses, investors turn to tactical managers who offer the golden elixir of active management; by using various asset classes and different strategies, they can get in and out when they need to, avoiding steep losses and offering better risk-adjusted returns. Rekenthaler then takes them to task for overpromising and underdelivering with none of the 57 funds they considered outperforming Vanguards Balanced Index (VBIAX), a 60/40 blend portfolio and a natural starting point for any advisor building out a client portfolio. Mr. Delmore focuses more on risk-adjusted returns using the Sharpe ratio while Mr. Rekenthaler focuses on absolute returns, but the net conclusion is the same, stay away from tactical funds because as Rekenthaler puts it “There is no measure by which tactical-allocation funds can be defended. They are indefensible.”
Do I think they’re right? Well it’s hard to argue with cold hard numbers but I’m going to do my best because I believe John Rekenthaler’s and Luke Delorme’s articles didn’t tell the whole story and overlooked a number of key arguments in defense of tactical funds or perhaps even active management in general.
I also have nothing but the highest respect for Morningstar; I was an intense user of Morningstar Direct when I was a mutual fund analyst and many of the methods I’ve employed over the years are very similar to those both author’s used in their articles. I too take a long-term view and rely on past performance, I’ve used the Sharpe ratio for essentially “unbenchmarkable” areas like tactical allocation although my preferred metric is the information ratio and finally I’ve done high-level sector comparisons using prior performance data to make allocation decisions. But with all due respect to my esteemed professional brothers-in-arms, I feel doing so in this situation is a disservice to advisors and potential investors everywhere which is why I wrote this piece.
So why have I decided to “defend the indefensible?” Well partly because I like a challenge and like Rhett Butler, I have a weakness for lost causes but there’s a lot more to it than that. For those who don’t know and in the interest of full disclosure, I’ll confess to having started my career with an investment manager that offered a variety of investment strategies including tactical so I know all-too-well the challenges that have plagued investors in that space. I’ve long since left that world behind and certainly am not writing this out of a desire to whitewash bad performance or to claim that investors were too quick to hire and too quick to fire when it came to tactical management.
I know, I started by saying that “I haven’t come to praise Caesar…” and I’m already trying to turn that around. First, I’m not a current holder of any tactical funds, employed by any fund family or receiving any form of compensation for writing this. Everything I write here is my own opinion and I’m simply doing this because I feel that it’s important to educate investors through in-depth analysis and once you see the size of this piece, you’ll know I’m loaded for bear.
A final note before we get into it, all of the data I’ve used in this piece is from Morningstar where I have a subscription for retail investors, not a professional license of any sorts which means my data is somewhat limited. I’ll built my own list of tactical managers using their premium fund screener looking for managers in the tactical allocation category and oldest share class without concern over initial investments or whether they were closed or not at the time of this article. I wanted a more complete view of the sector, which means including funds with a $1,000,000 initial investment versus $0 and up retail oriented products.
Now with that done, grab a cup of coffee or a beer and settle in, because there are three key arguments to consider when deciding whether you want to take a pass on tactical managers.
First Issue: Tactical Allocation is a Dumping Ground for Misfit Funds
Let’s start by focusing on what I mean when I say that funds in the tactical allocation space aren’t benchmarkable, which is not a word….yet, so instead we’ll say it isn’t homogeneous. Take Morningstar’s Large Blend space, home of S&P 500 index funds and a natural starting point for any advisor looking to build out a diverse portfolio. Morningstar’s official category definition as of April 2016 is a little long but:
“Large-blend portfolios are fairly representative of the overall US stock market in size, growth rates and price. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of US industries, and owing to their broad exposure, the portfolios’ returns are often similar to those of the S&P 500 Index.”
So essentially, if your portfolio is mostly large or giant cap names and you keep your weighting to value and growth stocks below say 30% each and congrats, you’re a large blend fund. The fact that nearly every fund in that category is officially benchmarked to either the S&P 500 or Russell 1000 makes it even easier to spot them and it also means they pull all their portfolio holdings from those universes and have a relatively high R2 to either of those benchmarks.
In other words, if looks and acts like the S&P 500, Morningstar can be reasonably sure it’s a large blend fund. That homogeneous nature makes it easy for Morningstar to assign funds to the category and allowing us to make easier comparisons between active and passive funds or different management styles. For that, we can ditch the Sharpe ratio in favor of the information to tell how good each manager is at stock picking and since every fund pulls from almost the same universe, comparing a fund to the category average or the averages to the broader market is very workable.
Tactical allocation is literally the exact opposite situation which makes trying to find the right fund challenging and using category average statistics somewhat misleading. Like nontraditional bond, tactical allocation was intended as a refinement on the existing category definition system to help investors make more apples-to-apples comparisons and more importantly, to keep these funds from screwing up the comparables for other categories. Look at the very broad methodology Morningstar uses for fund classification:
“Tactical Allocation portfolios seek to provide capital appreciation and income by actively shifting allocations across investments. These portfolios have material shifts across equity regions, and bond sectors on a frequent basis. To qualify for the tactical allocation category, the fund must have minimum exposures of 10% in bonds and 20% in equity. Next, the fund must historically demonstrate material shifts in sector or regional allocations either through a gradual shift over three years or through a series of material shifts on a quarterly basis. Within a three year period, typically the average quarterly changes between equity regions and bond sectors exceeds 15% or the difference between the maximum and minimum exposure to a single equity region or bond sector exceeds 50%.”
Now that’s a mouthful and in practice, what it means is that Morningstar’s approach is probably more along the lines of “if it can’t be easily benchmarked, has high turnover and no consistent weighting to any asset class, dump it in tactical allocation.” Hence the term misfit, they don’t actually fit easily into any category. Funds without a strong R2 to a particular benchmark, allocations to multiple asset classes (U.S. equity, non U.S. equity, International Bond, etc) and/or high turnover seem to get classified as tactical allocation regardless of their underlying strategy although having tactical in the name doesn’t help much either. Drilling deeper, some funds have extremely high turnover while others are in the low single digits, some have large cash positions while others are fully invested, some are volatile while others have an almost bond-like standard deviation.
What that means for the average investor or their advisor is that since the tactical allocation is mostly a hodge podge of different styles, looking at the category average return or Sharpe ratio doesn’t really tell you all that much about how the investment style overall has performed. Large Blend and Large Value both have relatively high homogeneity making the comparison easier, but what about comparing non-traditional bond to intermediate-term bond? Some managers are long duration, some are short duration, some are credit-oriented, some sovereign, etc. What a comparison will tell you is just that not being long duration all the time wasn’t a great idea over the last few years but not much more than that.
Obviously Morningstar’s viewpoint is that their high turnover and lack of consistency is exactly why they can’t be assigned to other categories, but it also means that it’s next to impossible to use category average returns for anything but the broadest discussions and given how varied the returns of some of these strategies are even from month-to-month, at best they can only tell you about how real return managers have fared in aggregate over the last few years which brings me to the next dilemma.
Problem 2: Past Performance is No Guarantee of Future Results
Now that’s out of the way, let’s go after the low hanging fruit where biggest flaw when studying tactical funds (or any mutual fund for that matter) is an assumption, that while never stated in either of these articles, certainly managed to get my mutual fund “spidey sense” a-tingling. Most analysts focus on the one, three and five-year trailing performance and standard deviation for funds in the space which is the logical thing to do when considering funds for a long-term investor and there’s no doubt about it, the funds that Morningstar puts into the tactical allocation space have underperformed VBIAX and the broader market. In fact, saying they’ve underperformed is like saying the Cleveland Browns haven’t lived up to their potential. Technically true but WAY understating the situation.
So given the underperformance relative to the broader market, not to mention the higher fees, the conclusion is that you should obviously avoid the space which is fine advice EXCEPT for one tiny issue; that argument relies on the assumption that the market’s future is going to look very much like it’s past leaving tactical funds to continue underperforming when in fact, the opposite is true.
Now I’m not talking about some magical Callan table that I “Back to the Future 2’ed” from 2030 showing gold funds outperforming for the next five years but that right now, in 2016, as of 9/22, there are 28 tactical funds outperforming VBIAX and while the tactical category average return is lagging 200+ bps behind Morningstar’s Moderate Target risk return, that figure is half of that of the trailing 1 and 3 year numbers. And it’s not just the multi-asset income funds this time around but a wide array of funds outperforming the static benchmark. Even the now infamous perma-bear John Hussman is enjoying some love with his Hussman Strategic Total Return up over 11% YTD.
I know, you’re thinking something nasty about “even a broken clock is right twice a day” or something along those lines right to which I think anyone in the business would prudently respond “and so what?” You wouldn’t load up on utilities coming out of a recession or long-term Treasuries if the Fed was in the position to hike rate right? Why not use the right tool for the job?
According to Morningstar, to even be a tactical allocation fund you have to have some allocation to bonds and a demonstrated willingness to switch asset classes, meaning you’re likely to underperform equities during a strong rally like that from 2013 and 2014 while outperforming during periods of market turbulence. For a lot of clients that’s likely to be a deal breaker but remember that most managers in the space focus on delivering performance on a risk-adjusted basis with less step drawdowns. I know there are examples out there of managers who promised investors that because of their flexible mandates, they’ll outperform when the market is up or down and then never delivered. And while time may heal all wounds, investors have LONG memories when it comes to their money.
However, there are some managers, maybe because of a more limited focus, have done right by their clients over the years including some of this year’s stronger performers. There wasn’t a deep roster of talent to choose from in 2011 but while Hussman may have been up 4% but the real winner was the Invesco Balanced Risk Allocation Fund, up over 10% although the following years were less kind. But if it’s diversification you want and a healthy Sharpe ratio, why not the Blackrock Multi-Asset Income Fund that was up over 4% in 2011 or the Hundredfold Select Alternative Fund or even one of 2016’s average performers (but with among the lowest volatility), the Putnam Dynamic Asset Allocation Fund?
Problem 3: What Would You Say That You Do Here?
So having poked holes in the idea that all tactical funds are created equal along with pointing out that the recent turbulence has helped their returns so far in 2016, what else could I possibly find wrong with the article? Well before I climb down from my soapbox, there’s only one major issue that from my own experience with tactical managers I can tell is perhaps the most important and that Morningstar never addressed. They focused on the risk/reward makeup and how funds in the tactical space compare to a generic 60/40 equity-to-bond blend with the message being essentially that since tactical managers have a lower Sharpe ratio, you should avoid them. The topic of diversification is totally ignored which does a disservice to clients everywhere.
It’s interesting to me on several levels because a 60/40 portfolio is considered the basic starting point for building a diversified portfolio, sort of a “when in doubt, use this” approach to asset allocation although if we only cared about the Sharpe ratio, we wouldn’t have bothered with equities over the last few years. Morningstar’s own data shows that the Barclays U.S. Aggregate Bond Fund (AGG) has outperformed the S&P 500 ETF (SPY) over the last three and five year periods meaning holders of a 60/40 fund made one of two decisions. They wanted the 60% equity exposure for return maximization or they wanted it for return diversification. After all, despite the recent Fed induced weirdness, you’d expect bonds and equities to not rise at the same time by the same amount with lower correlations so over a long period of time you could reduce your portfolio’s risk while earning approximately the same return as if you were 100% in equities.
Given the less-than-stellar performance history of most funds in the tactical space, I’m certainly not going to try and make an argument that they’re good for return maximization and let’s be honest, if you want lower correlations and high potential returns, there are plenty of gold mining funds out there to choose from. Or you could choose to employ a core-satellite strategy and pick your own asset classes or alternative managers to fill that space, but to be honest, why would you? It cuts into your client time and forces you to spend a significant chunk of your day researching, not to mention opening up a host of issues with compliance.
But while their absolute return has lagged the broader equity and bond markets, a number of tactical funds have respectable risk-adjusted returns and with less than 100% correlations to a 60/40 portfolio meaning they can offer return diversification. Unfortunately, having a lower correlation in 2016 means you’ve underperformed overall and since most clients only care about beating an equity benchmark (and so their advisors have to as well), employing a diversification strategy and sticking with it are harder than ever. Finding a good allocation manager to fill that spot is an easy way to add return diversification to your portfolio but it requires you to being willing to stick with a manager and endure periods where you don’t outperform an equity index.
Take the example of combining VBIAX with Meeder Muirfield Fund (FLMFX), one of the top performing funds in the tactical allocation space which was discussed in Luke Delmore’s piece. For laughs, I decided to set up a test portfolio in Morningstar with 90% in VBIAX, 10% in FLMFX with an inception date of 12/31/2010. Unfortunately, my basic Morningstar subscription doesn’t provide me with all the relevant risk stats, but you can see that while FLMFX has been an underperformer relative to VBIAX, the amount of underperformance on an annualized basis isn’t as bad as you’d think. The test portfolio has a five-year annualized return of 8.37% compared to 8.53% for VBIAX and 16.3% for the S&P 500. FLMFX did outperform in 2012 and 2013 before lagging behind VBIAX in 14 and 15 while 16 is still too close to call.
Assuming you’re keeping an open mind and willing to spend the time to search for a good manager, just how exactly are you planning to use them in your portfolio? I’ve heard everything from a small position in the low single digits to something along the lines of ALL THE MONEY and while I’m sure there are plenty of folks out there who’d love to be the core of your portfolio, from my own experience I can tell you that most managers would never advocate that and would instead encourage you to think about using them as a diversification tool within your larger strategy. Low single digits means your diversification manager isn’t adding that much diversity to your portfolio while getting above 20% over the last few years meant significant underperformance (and a fired advisor.) Ultimately the answer depends on which risk is more manageable, underperforming the index on the upside or downside.
So now the only thing conspicuously missing from this review is a short-list of funds worth checking out in the space and if that’s what you’ve been waiting for, I hate to disappoint but there isn’t one. Partly it’s because this article was long enough already and partly because, as I pointed out many times before, you have to take each fund in the tactical allocation space on its own merits. The space is so diverse that you can just do a one-off quick look at a fund and think you know it all. You have to understand how the fund works within the larger portfolio you’re managing.
But stay tuned, the Yinzer Analyst will hope to have a list up shortly of both tactical and world allocation funds that can help diversify your portfolio. Gotta give you a reason to keep coming back for more.