Once again the charge of being a “market timer” is being hurled at active portfolio managers in a recent discussion thread initiated by Bob Veres on Financial-Planning.com. The term itself seems to get planners into such a tizzy, though, while the actual definition of what constitutes “market timing” is unclear at best; perhaps a new definition of market timing is in order. To say the least, the most common definition of market timing, the one that implies that market timers are similar to “retail” day-traders willing to take their portfolios to extreme asset allocations based on their very short-term predictions of future market behavior, is badly in need of an upgrade.
EDITOR'S NOTE: This post was written jointly with Ken Solow, Chief Investment Officer for Pinnacle Advisory Group and author of "Buy and Hold is Dead (Again)". You can see more about Ken and his firm at the Pinnacle website, and their blog Echoes From The Pit. Pinnacle Advisory Group currently offers portfolio consulting services for RIAs and planners interested in outsourcing their portfolio management services.
For instance, let’s look at a common version of a transaction that appears to constitute “market timing” in the Veres discussion thread on Financial-Planning.com: a transaction that involves selling an overvalued security (or asset class) in favor of buying an undervalued security or asset class. Since the purchase and sale involves some shift in asset allocation or security selection, and must be executed with some timing, it is implied as market timing. With this particular transaction in mind, though, let’s consider some of the following questions:
1.Is the act of selling an overvalued security or asset class (impliedly one that has a significant possibility for underperformance or price decline) in order to purchase an undervalued security or asset class an activity that is risk reducing or risk increasing?
2.If you instead ignore the valuation implications of overvalued asset classes and simply hold the same static allocation that includes those overvalued investments no matter what, is that activity risk reducing or risk increasing?
3.If you rebalance a buy and hold portfolio by selling the investment that has become overweighted and buying the one that has become underweighted – which also implies that the rising one has become overvalued and the declining one may be undervalued – does that constitute market timing? If it does, then is anyone who rebalances a “buy and hold” portfolio also a market timer? If not, then what’s the difference between rebalancing amongst overweighted and underweighted securities in this question and selling overvalued securities to buy undervalued ones in the prior question?
4.Perhaps the difference is that active valuation decisions require “subjective” decisions; how can you identify when an asset class is overvalued or undervalued? For example, do you think stocks are overvalued at 20x forward operating earnings in a 0% interest rate environment? How about 30x earnings? 40x earnings? 50x earnings? But the point is simple; Is there ANY valuation that would cause you to conclude that, in a particular case, stocks (or some asset class(es)) are overvalued? If you then become willing to sell at SOME point, however extreme, is that “bad” market timing, or is that a risk reducing activity?
5.How much of an improvement in performance do you need in order to make the case that an act of market timing was beneficial to your clients? Is market timing only effective if you avoid ever having declines, as implied by a comment by Veres in the aforementioned thread? What if you “merely” provide 50 or 100 basis points of outperformance? Or 200 basis points? Or 1,000 basis points?
6.If the markets (passive benchmarks) don’t deliver historical average returns because of an extended period of suboptimal performance, then what recourse, other than hoping for higher returns in the future, do you have as a financial planner and an investment professional to help your clients achieve their goals? If your only plan for dealing with an extended period of weak market returns is to buy and hold and hope that better returns arrive before your client runs out of money, does that constitute a plan, or just a hope?
7.If there was no academic evidence that conclusively shows that market timing leads to higher portfolio returns, yet the possibility remains that it could be possible, would it still be worthwhile to attempt to earn them?
If you answer yes to any of the questions above, perhaps saying “I love market timing!” isn't always a bad thing. As Veres' article questions: is it time for planners to consider the practical possibility that some form of “market timing” is required in at least some types of difficult markets, and even more so if they want to have the opportunity to add value to client portfolios above market returns?
This is not to say that active management is easy. It’s simply to make the point that it might be necessary when long-term academically accepted methods of valuation say that markets are expensive and exposed to increased risks of sub-standard returns, which in turn produce results that cannot achieve client goals. Especially since, unfortunately, that appears to be the situation we are in today.
Of course, once the possibility exists that “market timing” might be necessary, even just sometimes at valuation extremes, the conversation should not be about WHO is an ‘evil’ market timer, but instead about HOW to execute such transactions more effectively (or how to outsource them to an investment manager who wishes to do so?). And perhaps to acknowledge that there are ways to shift client portfolios in a constructive manner besides the day-trading all-in-all-out style that is so commonly lambasted as market timing. In other words, we need a better definition of market timing – or at least, a way to more clearly differentiate between “good” and “bad” ‘market timing’.
So what do you think? Does shifting a portfolio in response to market valuation extremes constitute “market timing”? Or is it just prudent management? How much does a portfolio allocation have to change for it to be a “tilt” versus a “market timing” transaction? Do all portfolio changes have an aspect of market timing to them?