Why and How to Pick Tactical for your Portfolio

This note seeks to make two points about why and how to pick a tactical manager. Section 1 shows that Tactical can provide better returns and better risk-adjusted returns than a static allocation to asset class buckets. Section 2 shows that within tactical, picking a diversified portfolio of managers is vital to achieving Tactical’s promise.

Section 1: Move beyond size/style indexes: Tactical is your best bet for performance

Tactical asset allocation strategies have grown steadily over the past decade to become the majority investing style. To be sure, 13 out of the largest 25 funds in Morningstar’s ETF Landscape summary report Q3 2013 identify as tactical. Out of 178 managers surveyed by the Greenwich Associates US Exchange Traded Funds study in 2013, 72.4% employed tactical adjustments using ETFs.

What has made Tactical so popular? In secular bull markets such as the one in the 90s, a buy and hold strategy was acceptable. But diversification within the style/size boxes hasn’t protected funds from a market collapse, especially if all asset classes became highly correlated during those episodes.

Most Tactical ETF funds have higher risk-adjusted returns and lower drawdowns than traditional benchmarks.

The Tactical Strategies’ Index, shown in the Chart below, is a current AUM-weighted index of 29 tactical funds (with AUM greater than $100 million) using Morningstar data. As seen in Chart 1, tactical strategies as an aggregate group have consistently outperformed the S&P 500, 60/40 portfolio and HFRI Hedge Funds’ Composite both historically and more recently.

Chart 1: Cumulative Risk-Adjusted Returns of Tactical Index vs. benchmarks. The average Tactical strategy has better risk-adjusted performance against the S&P, 60/40 and the HFRI hedge funds index.

DS 1

Source: Morningstar, Astor Research

Tactical funds are also better positioned to respond to market downturns by shifting allocations quickly and efficiently. The aggregated tactical strategies index has shown lower drawdown than the S&P 500, especially in periods of market distress (Chart 2).

Chart 2: % Drawdown for the Tactical Index and the S&P 500 from Jan 1996- Apr 2013

ds2

Source: Morningstar, Astor Research

Adding the average tactical manager to a static portfolio has improved returns, reduced volatility and brought down drawdowns as tactical strategies search among the asset classes for better alpha without charging hedge funds’ fees.

To illustrate, we added a 20% average tactical strategy to static 60/40 portfolio. As shown in the chart 5, $1000 invested in a 50% S&P 500, 30% AGG and 20% tactical portfolio in Jan 1996 would have generated $4300 today and only $3270 in a 60/40 portfolio. Adding even a small exposure to tactical in an index-following passive portfolio has significantly improved returns while bringing down the overall portfolio risks as demonstrated by the performance of a 50% stocks/30% bonds/20% tactical portfolio versus 60% stocks/40% bonds.

Chart 3: Performance of a 50% stocks/30% bonds/20% tactical portfolio vs. benchmarks

ds3

Source: Morningstar, Astor Research

Section 2: Diversify your tactical managers; diversifying assets is not enough

In the following section, we discuss strategies for exposure to the tactical space. In our research, we find that investing a portfolio of tactical managers is a better investment strategy for adding tactical than using a single manager.

Tactical ETF managers are not substitutable

The performance of tactical ETF managers is much less correlated than that of traditional passive and even of active mutual fund managers. The average pairwise correlation of the 15 biggest large-cap mutual funds is high at 0.93. Compared to that, the largest 15 tactical managers show a much lower mean correlation of 0.55. This heterogeneity illustrates the benefits of diversifying with and diversifying amongst the tactical managers themselves.

To quantify the benefits of diversification at the manager level, we ran a simulation where we compared the performance of a randomly selected diversified portfolio of 3 managers with a single manager. Chart 4 shows the simulation results: the bars represent the distribution of excess risk-adjusted return of a portfolio of 3 tactical managers over a single tactical manager. For 70.5% of the iterations, the portfolio had a higher Sharpe ratio than a single manager.

Chart 4: Simulation showing probability of excess risk-adjusted returns from investing in a randomly selected portfolio of 3 tactical managers versus a single tactical manager.

ds4

Source: Morningstar, Astor Research

Not only does picking more than a single tactical manager add diversification benefits, it also reduces the pressure of correctly guessing who the next period’s best performing tactical manager will be. The more diversified the portfolio is and the less correlated the managers are, the more likely it outperforms a randomly selected manager.

Summary:

  • Tactical, as an investment approach, has evolved from the fixed asset-class silos into a multi-asset ‘go-anywhere’ approach that has shown better risk-adjusted performance and lower drawdowns especially during market downturns.
  • Adding a small exposure to tactical has significantly improved returns while bringing down the overall portfolio risks as demonstrated by the performance of a 50% stocks/30% bonds/20% tactical portfolio versus 60% stocks/40% bonds.
  • Due to the heterogeneity among tactical strategies, there are diversification benefits from investing in a portfolio of tactical managers instead of using a single manager in order to get exposure to Tactical.

-Deepika Sharma