The foundation of investment education for CFP certificants is modern portfolio theory, which gives us tools to craft portfolios that effectively balance risk and return and reach the efficient frontier. Yet in his original paper, Markowitz himself acknowledged that the modern portfolio theory tool was simply designed to determine how to allocate a portfolio, given the expected returns, volatilities, and correlations of the available investments. Determining what those inputs should be, however, was left up to the person using the model. As a result, the risk of using modern portfolio theory – like any model – is that if poor inputs go into the model, poor results come out. Yet what happens when the inputs to modern portfolio theory are determined more proactively in response to an ever-changing investment environment? The asset allocation of the portfolio tactically shifts in response to varying inputs!
(Editor’s Note: A version of this article originally appeared in the June 2012 issue of the Journal of Financial Planning in the Trends in Investing Special Report.)
The evolution of the industry for much of the past 60 years since Markowitz’ seminal paper has been to assume that markets are at least “relatively” efficient and will follow their long-term trends, and as a result have used historical averages of return (mean), volatility (standard deviation), and correlation as inputs to determination an appropriate asset allocation. Yet the striking reality is that this methodology was never intended by the designer of the system itself; indeed, even in his original paper, Markowitz provided his own suggestions about how to apply his model, as follows:
To use [modern portfolio theory] in the selection of securities we must have procedures for finding reasonable [estimates of expected return and volatility]. These procedures, I believe, should combined statistical techniques and the judgment of practical men. My feeling is that the statistical computations should be used to arrive at a tentative set of [mean and volatility]. Judgment should then be used in increasing or decreasing some of these [mean and volatility inputs] on the basis of factors or nuances not taken into account by the formal computations……One suggestion as to tentative [mean and volatility] is to use the observed [mean and volatility] for some period of the past. I believe that better methods, which take into account more information, can be found.”– Harry Markowitz, “Portfolio Selection”, The Journal of Finance, March 1952.
Thus, for most of the past 6 decades, we have ignored Markowitz’ own advice about how to apply his model to portfolio design and the selection of investments; while Markowitz recommended against using observed means and volatility of the past as inputs, planners have persisted nonetheless in using long-term historical averages as inputs and assumptions for portfolio design. Through the rise of financial planning in the 1980s and 1990s, though, it didn’t much matter; the extended 18-year period with virtually no material adverse risk event – except for the “blip” of the crash of 1987 that recovered within a year – suggested that long-term returns worked just fine, as they led to a stocks-for-the-long-run portfolio that succeeded unimpeded for almost two decades. Until it didn’t.
As discussed in the 2006 Journal of Financial Planning paper “Understanding Secular Bear Markets: Concerns and Strategies for Financial Planners” by Solow and Kitces, the year 2000 marked the onset of a so-called Secular Bear Market – a one or two decade time period where equities deliver significantly below average (and often, also more volatile) returns. The article predicted that the sustained environment of low returns would lead planners and their clients to question the traditional approach of designing portfolios based on a single, static long-term historical average input (which leads to a buy-and-hold portfolio), and instead would turn to different strategies, including more concentrated stock picking, sector rotation, alternative investments, and tactical asset allocation. In other words, stated more simply: planners would find that relying solely on long-term historical averages without applying any further judgment regarding the outlook for investments, as Markowitz himself warned 60 years ago, would become increasingly problematic.
The Growing Trend of Tactical
Although not widely discussed across the profession, the FPA’s latest Trends in Investing study reveals that the rise of tactical asset allocation has quietly but steadily been underway, and in fact now constitutes the majority investing style. Although not all financial planners necessarily characterize themselves in this manner, the study revealed that a shocking 61% of planners stated that they “did recently (within the past 3 months) or are currently re-evaluating the asset allocation strategy [they] typically recommend/implement” which is essentially what it takes to be deemed “tactical” in some manner.
When further asked what factors are being re-evaluated to alter the asset allocation strategy, a whopping 84% of respondents indicated they are continually re-evaluating a variety of factors: 69% indicated following changes in the economic in general, 58% indicated they watch for changes in inflation, and another 58% monitor for changes in specific investments in the portfolio. Notably, only 14% indicated that they expected to make changes based on what historically would have been the most popular reasons to change an investment, such as changes in cost, lead manager, or other administrative aspects of the investment.
Although not directly surveyed in the FPA study, another rising factor being used to alter investment allocations appears to be market valuation, on the backs of recent studies showing the value and effectiveness of the approach, such as “Improving Risk-Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies” by Solow, Kitces, and Locatelli in the December 2011 issue of the Journal of Financial Planning, and more recently “Withdrawal Rates, Savings ratings, and Valuation-Based Asset Allocation” by Pfau in the April 2012 issue, along with “Dynamic Asset Allocation and Safe Withdrawal Rates” published in The Kitces Report in April of 2009.
Notwithstanding the magnitude of this emerging trend towards more active management, it doesn’t necessarily mean financial planners are becoming market-timing day traders. The average number of tactical asset allocation changes that planners made over the past 12 months was fewer than 2 adjustments, and approximately 95% of all tactical asset allocators made no more than 6-7 allocation changes over the span of an entire year, many of which may have been fairly modest trades relative to the size of the portfolio. In other words, planners appear to be recognizing that the outlook for investments doesn’t change dramatically overnight; however, it does change over time, and can merit a series of ongoing changes and adjustments to recognize that.
Tactical Asset Allocation: An Extension of MPT
At a more basic level, though, the trend towards tactical asset allocation is simply an acknowledgement of the fact that it feels somewhat “odd” to craft portfolios using long-term historical averages that are clearly not reflective of the current environment, whether it’s using a long-term bond return of 5% when investors today are lucky to get 2% on a 10-year government bond, or using a long-term historical equity risk premium of 7% despite the ongoing stream of research for the past decade suggesting that the equity risk premium of the future may be lower.
Consistent with the idea that financial planners are recognizing tactical asset allocation as an extension of modern portfolio theory and not an alternative to it, a mere 26% of financial planners answered in the Trends in Investing survey that they believe modern portfolio theory failed in 2008. For the rest, the answer was “no”, modern portfolio theory is still intact, or at least “I don’t know” – perhaps an acknowledgement that while MPT may still work, many of us lack the training in new and better ways to apply it. Nonetheless, that hasn’t stopped the majority of planners adopting a process of making ongoing changes to their asset allocation based on the economic outlook and other similar factors.
Unfortunately, though, perhaps the greatest challenge for planners implementing tactical asset allocation is that we simply aren’t trained to do so in our standard educational process. Some financial planning practices are responding to the challenge by investing in training, staff, and/or research to support a more tactical process. Others are responding by outsourcing to firms that can help; the Trends in Investing survey showed nearly 38% of advisors intend to outsource more investment management over the next 12 months, and 42% are already outsourcing more now than they were 3 years ago.
Regardless of how it is implemented, though, the trend towards tactical itself appears to have grown from a broad dissatisfaction amongst planners and their clients that the “lost decade” of equity returns has left many clients lagging their retirement goals. Even if diversified portfolios have eked out a positive return, it is still far behind the projections put forth when clients made their plans in the 1990s, forcing them to adjust by saving more, spending less, or working longer, to make up for the historical returns that never manifested. And as long as the secular bear market continues, the strategy will continue to be appealing. Ultimately, though, the sustainability of the tactical asset allocation trend will depend on it delivering effective results for clients.
So what do you think? Would you characterize yourself as a tactical trader? Is tactical asset allocation a short-term phenomenon, or here to stay? Is tactical asset allocation simply modern portfolio theory done right, or does it represent an entirely new investing approach?