In a recent post on Alliance Bernstein's blog on investing, the author discusses “The Marriage of QDIAs and Managed Volatility in US DC Plans.” The post is mostly focused on controlling market risk in TDFs by adding a volatility-modifying component to the target-date funds glidepath (i.e., a tactical asset allocation).
With the sudden fall in the markets related to the Great Recession of 2007-2009 and the subsequent remarkable rebound — as well as all the talk about “fat tails” and “black swans” — it is tempting to want to do something to protect DC investors’ portfolios from the vagaries of the capital markets. In spite of the attraction of pursuing tactical asset allocation (in lieu of a strategic approach to portfolio construction and maintenance), plan advisors should weigh the risks before adopting this type of investment strategy.
Given that many researchers believe the financial markets show strong evidence of being a deterministic nonlinear system, which would make them susceptible to the butterfly effect (registration required), it could be argued that a manager would need to use chaos theory in order to make accurate predictions of short-term market cycles. This, however, is a theory that is more the subject of research than actual application, at least insofar as it relates to the financial markets.
The butterfly effect aside, there is no doubt that the world economy is becoming increasingly complex and more difficult to predict. Consider a recent DTCC white paper which reports that “systemic risks facing the global financial services industry are growing in complexity, are more difficult to anticipate and that new gaps continue to surface.”
In summary, the chief risk of tactical management is that there are so many “known unknowns and unknown unknowns,” increasing the chance of tactical moves being more likely to be wrong than right.
Some would argue that the same could be said about making long-term forecasts on which strategic allocations are based. However, market swings are much more likely to smooth out over longer time periods, as we have seen with the S&P 500 index falling 57% from its October 2007 peak at 1,565 to a trough of 676 in March 2009 and steady climb to over 1,700 today.
Managing a portfolio in a strategic versus tactical manner is the difference between riding out an entire market cycle versus trying to predict the ebbs and flows of each market cycle. Even if there are grand masters at the game being played out on the world economic chess board, it is best to let well-heeled investors roll the dice on these managers in expensive hedge funds, rather than make participant monies dependent on innovative forecasting models that may or may not accurately predict entry and exit points of any given asset class.
The rise and fall of the tech bubble would seem to build a strong case for the need for tactical asset allocation. However, a strategically well-crafted portfolio that was highly diversified and continually rebalanced during this period was the type of model that ultimately survived the sudden collapse quite well and was also positioned to take advantage of those asset classes (e.g., value, emerging markets, real estate) that had been shunned during the bubble, only to come into to favor after the crash.
Then there was 9/11, which literally came out of the blue. Finally, it would have been good to have been able to predict the Great Recession and be clever enough to determine the exit and entry points. However, a minority of tactical managers saw it coming, and very few predicted how significant the rebound was going to be. As Keynes famously stated, “Markets can remain irrational longer than you can remain solvent.”
The advisor who considers taking a tactical approach should also consider the old adage: “No good deed goes unpunished.” This is to say that if the advisor advocates timing the market and is correct, it makes them a hero. But if the advisor is wrong, they will be held accountable for missed gains. We have all seen those charts that show the huge impact of being out of the market during a small number of crucial days in which there are mostly “unexpected” surges, especially in the equity markets. An advisor who takes a well diversified, continually rebalanced, risk-matched, strategic approach to asset allocation normally has little for which to apologize. This calls for one more, though less famous, quote from Keynes: “It is better to be roughly right than precisely wrong.”
