Some investors look to tactical asset allocation to protect them when markets get rough. However, recent evidence from Morningstar (MORN) shows that many TAA funds fail to provide adequate protection.
The objective of TAA is to provide better-than-benchmark returns with potentially lower volatility by shifting asset-class allocations, depending on projected returns. For example, a fund benchmarked against a 60 percent S&P 500 Index/40 percent Barclays Capital Aggregate Bond Index might shift to 5 percent S&P 500/50 percent Barclays Aggregate/45 percent cash if the manager thought a bear market was coming.
In reality, TAA is just a fancy name for market timing, not to mention a chance for money managers to charge higher fees. Proponents claim that it can be especially valuable in bear markets, or periods of high volatility. Unfortunately, the evidence suggests that allowing managers to zig and zag is actually a disadvantage.
In its most recent issue of "Morningstar Advisor," the investment researcher updated an earlier study on TAA funds that showed that 70 percent of funds underperformed the Vanguard Balanced Index Fund (VBINX). Did the rough markets we saw last year give TAA funds a chance to redeem themselves? Apparently not. Again using VBINX as the benchmark, Morningstar found:
- Very few TAA funds generated better risk-adjusted returns than VBINX.
- Just nine of the 112 TAA funds in existence over the period August 2010-December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns).
- Only 27 funds experienced smaller peak-to-trough declines than VBINX.
- Only 14 of the 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring/summer 2010 correction, and the recent European debt-related downtown. Put another way, just 17 percent of them consistently provided the insurance investors were paying for.
- In a simulation of various hypothetical portfolios over the 10-year period ending December 2011, the average TAA fund would have provided very little in the way of incremental diversification.
Bottom line: TAA fund investors incurred heavy fees because of the active management, and returns were poor. In short, we have another game where the winners are product purveyors, not investors.
Photo courtesy of waitscm on Flickr.