Posted on January 13, 2012 by David Laidlaw
Money management styles are often categorized as either strategic or tactical. Strategic investment managers position portfolios for their clients in various categories such as asset classes or industry sectors to benefit from the returns available in those categories. Tactical managers rotate between those categories to benefit from trends that they see developing that would advantage one category versus another.
For example, a strategic equity investor would buy stocks to benefit from high future returns while assuming a certain amount of risk given the volatility inherent in common stocks. On the other hand, a tactical manager might rotate between stocks and cash with the expectation that there are signals that make equity investing profitable at certain times and too risky at others. During these risky intervals, the tactical manager would sell stocks and invest in safer assets such as cash or high quality bonds. When the tactical manager felt that stocks were poised to rise, he or she would buy stocks and sell cash and bonds.
Our company is a strategic investment manager. We determine an appropriate asset allocation for our clients based on their risk tolerances and invest a set percentage of the portfolios under our management in risky assets and a certain percentage in safer assets. In general, we invest in stocks as the risky class and invest in bonds as the safer securities. For the equity portion of portfolios, we choose individual stocks according to an analysis of their fundamentals and hold those stocks. We do not rotate between stocks and cash or aggressive sectors and defensive sectors of the stock market.
Based on observations at a broker-sponsored conference we attended last fall, our investment strategy is pursued by a minority of advisors. The vast majority of advisors and managers who attended the event appeared to adhere to a tactical philosophy. Many of the sponsoring managers at the conference explained their proprietary models that allowed them to determine when it is optimal to be in risky assets and when it is optimal to be in safe assets. Their past results appear impressive and their firms are growing explosively. A saleswoman from one firm indicated that her firm passed the $1 billion in assets under management mark last year and that it now manages over $4.5 billion. However, a closer examination of the these firms’ performance presentations show model historical returns rather than the actual performance of real money under management.
I am very skeptical that these tactical strategies will work as advertised since they basically rely on the ability to time the market. Market timing requires two correct decisions, when to enter/buy the market and when to exit/sell the market. On average, a manager would need to be correct over 70% of the time for both of these decisions (since mathematically 0.7X0.7=0.49) to do better than a buy and hold strategy. The market is so volatile that is impossible to consistently predict market trends over short time frames. Markets move according to a global group consciousness without discernible patterns. These movements are also violent and could cause significant losses if timing decisions were made incorrectly. For instance, assume a tactical allocator managed an all equity account and made a couple of poor decisions during the past year. Assume the first decision was to sell out of all stocks in mid- August and the second was to purchase stocks again in late October. This pattern would have produced a loss of 15% this year instead of a gain of 2.1% (S&P 500 2011 total return) produced by holding stocks for the full year.
Advisors have most likely become tactical since they lost so much money for their clients in 2008. The credit crisis caused many managers to lose confidence in strategic allocation strategies since they were not able to handle the stock market volatility. Market timing is one strategy that will never completely disappear; however, we hope that it becomes less prevalent since the potential for losses is significant.