With the financial crisis of 2008-2009, some planners appear to be considering – if not adopting – a somewhat more active approach. Unfortunately, though, for many planners any investment strategy that is not purely passive and strategic must be equated to “market timing” – a pejorative term. Yet the planners who have implemented some form of tactical asset allocation generally do not call themselves market timers; they recoil at the term as much as passive, strategic investors do. So where do you draw the line… what IS the difference between being “tactical” and being a “market timer”? In truth, it seems that once you dig under the hood, the differences are nuanced, but they are many, and significant.
The inspiration for today’s blog post stems from some ongoing discussions I’ve been having with several planners about what the difference is between “market timing” and “being tactical”, and the implication from many planners that anything which involves making a forecast of the future and changing your portfolio – in ANY way – to be “evil market timing” that risks client destitution. After all, as they point out, at some point you have to execute the change you’re trying to make, and you have to time that correctly, or you’ll lose money (or clients) even if you were right. Their case in point example: you could have been absolutely right in 1998 that the markets were headed for a crash, but unfortunately if you pulled your clients out of the market then, you probably wouldn’t have had any clients left by the time the crash finally arrived two years later!
Yet when I look at firms that implement tactical asset allocation, this kind of characterization – that you might try to get all the way out of the market ahead of a crash, be “too early” (or just flat out wrong), and lose all your clients – doesn’t seem to be the way financial planners who follow the approach are actually doing it.
First of all, the mischaracterized approach of being tactical implies that the planner will make forecasts that completely avoid all market declines; in essence, that tactical asset allocation is about generating absolute positive returns. However, in practice, that is often not the case, not is it at all necessary. Generating effective relative returns – i.e., beating a benchmark – is still not only an acceptable target for success, but almost by definition would mean that the tactical approach that beats its benchmark is beating its passive, strategic alternative. After all, as many planners are aware, saving just a few basis points per year in investment costs and expenses can really add up over the long term; similarly, “merely” generating 1%/year of relative outperformance (being down 19% when the market is down 20%, or being up 11% when the market is up 10%) can increase the growth of your wealth by almost 50% with cumulative compounding over several decades of lifetime saving and investing. Let’s not be guilty of applying a double-standard where we measure the value of active management on one scale, and the importance of saving fees and expenses on a difference scale, when it all has the same wealth impact. After all, in a year where the stock market loses 20% in a decline, that means “just” reducing equity exposure by 5% (e.g., from 60% in equities to 55% in equities) can produce an incredibly desirable 1% relative outperformance (by only losing 55% x 20% = 11% of the portfolio in a stock decline, instead of 60% x 20% = 12% of losses), and it’s the same benefit as saving 1% in expense ratios. But to say the least, having absolute positive returns as a benchmark is, simply put, quite unnecessary, and substantial value that radically improves a client’s success and standard of living over time can still be created with a far less onerous benchmark and far more modest shifts in allocation.
Which, indirectly, leads to the next notable difference between market timing and tactical asset allocation: the magnitude of typical changes, along with the time horizon for those changes. The stereotypical market timer is one who can move “all in” or “all out” of investments at their whim; it could be 100% in equities on Tuesday, 100% to cash on Thursday, and back to 100% in equities again next Monday. Tactical asset allocation, on the other hand, typically implements change in a far more modest fashion; depending on the firm, changes from 2% to 5% are more common, with some firms making changes in the 10% to 20% range. Although the latter may seem “extreme” to many planners, it is still far less than the 100%-in-100%-out style of the stereotypical market timer. In addition, most firms that employ tactical asset allocation have a much longer time horizon; rather than going all-in on Tuesday, out on Thursday, and back in on Monday again, tactical shifts often span time horizons of months or years, leading to “relatively” fewer transactions and allocation shifts that occur more gradually over time. This anchors back to the fact that tactical asset allocators are often looking from a more top-down, macroeconomic perspective, where the factors themselves only change so fast, and take time to be manifested in the markets. This can be contrasted with the market timer, who is often looking over an extremely short-term time horizon, where other factors (short-term technical indicators?) may be driving the process.
Notably, changes in portfolio also don’t have to be the “in-market or out-of-market” variety, either. Many tactical asset allocators focus on how their investment selection rotates based on market and economic factors; a highly successful tactical asset allocator may have held only 60% in equities over the past decade and never varied the equity exposure, but if it was small cap value from 2000-2004, international stocks from 2004-2007, defensive consumer staples stocks in 2008, and emerging markets in 2009-2010 during the post-crash rebound, clients may have doubled their money over the decade without any change in overall equity exposure. This may be contrasted with the market timer, who – at least in the stereotypical definition – tends to make changes between stocks and cash (i.e., “in” or “out” of the market), rather than all of the more nuanced shifts that may occur within the equity asset class(es) (or within bonds, or within alternatives, etc.).
Of course, it is still true that any transaction that changes an allocation involves some aspect of “timing” to the execution. But being allowed to simply make any change to the portfolio – which involves a timing to execute – seems to be a poor definition for what constitutes a “market timer” for financial planners. After all, even those who are strategic and passive and only execute changes to the portfolio via rebalancing still noticed that in late 2008, the month, week, day, or even hour that you executed just a “passive” rebalancing trade had a significant impact on the client’s returns given the incredible market volatility of those months. If trying to decide whether it is more prudent to rebalance in September, October, November, or December 2008 constitutes “market timing” then I guess virtually all of us are guilty of being market timers; which means to me, that’s a pretty useless way to define it, and we need a new definition of market timing.
So what do you think? Do you see a distinction between being tactical and market
timing? Or is it all market timing? Is it possible that being tactical may be appropriate for some planners or clients, even if market timing is still viewed as “risky”?