JActive asset allocation as an investment strategy has spawned both strong proponents and tough detractors over the years. We may see varying results when looking at different periods of performance, but many investment styles have similar periods for and against. So, while proponents and detractors argue, it should be noted that it may not be a question of whether or not tactical asset allocation works, but what type of environment you are in. find. With all the confusion and volatility in the markets today, it might be time to take a closer look at tactical investing.
As an example of the position of a detractor, last year morning star wrote a very negative article on tactical asset allocation stating that “this investment strategy is notoriously difficult to implement in practice” and did not recommend the investment approach, to say the least can say. The article, however, qualified their opinion by acknowledging a few tactical managers who have been able to implement tactical approaches with some success.
For a different perspective, we reached out to asset manager Morningstar, positively cited as generating “some of the best long-term returns in the category using a flexible approach to asset allocation”, the Leuthold Group – a Minneapolis-based market research and financial management firm that recently became a corporate member of the Institute. We asked the co-CEO of the Leuthold Group John Müller questions to better understand tactical asset allocation, dispel misconceptions, and discuss the unique place of investment strategy in today’s portfolios.
Horz: After being founded as an independent investment research company providing original analysis for the institutional market, why did you decide to create an investment management arm focused on tactical asset allocation and quantitative methodologies?
Muller: The decision to apply in-house research and analysis to an investable portfolio was made before I joined the company, but I know the story. Steve Leuthold was well known in institutional research circles and frequently published his market views, allocation recommendations, and more. The portfolio managers, who subscribed to the research and whose performance was measured daily, suggested Steve “put his money where he says”.
They involved being a good strategist and writing calls was one thing, while implementing decisions in an investable portfolio was another. Thus, in 1987, the Core Investment Portfolio was born. The net equity exposure in the portfolio was significantly underweight before the October crash, so Steve gained some credibility early on.
Horz: How do you define tactical asset allocation and how do you go about implementing the strategy? What disciplines need to be in place to execute a tactical strategy that won’t shoot you in the foot at the wrong time?
Muller: We believe tactical asset allocation is all about flexibility. Properly executing a tactical strategy in different market environments requires the latitude of a wide range of opportunities. Additionally, there is a certain level of agility required to implement a flexible strategy. To effectively manage a tactical asset allocation strategy, being smaller and not being limited in capacity is a huge advantage.
Finally, we strongly believe that you need to put processes in place to eliminate emotions and instill discipline. Our proven templates have helped us make tactical moves in difficult times, often going against the grain.
Horz: What are some of the different internal components or tools you use in your strategy that have been most effective?
Muller: We have a number of sub-strategies and models that we use in our flagship Core strategy that have contributed to our long-term success. Starting with our Major Trend Index (MTI) that we publish every week for our research clients. This model is designed to assess the overall health of stock markets and helps us position our portfolio to better reflect the current environment. The creation of the MTI dates back to the 1970s and although it has evolved over time, it still retains its main components.
Once we have determined our desired net equity exposure, we manage it with a balance between our long equity strategy (Select Industries) and our short equity strategy (AdvantHedge). We’ve been managing both of these strategies successfully for decades.
Select industries, as the name suggests, leverages our monthly industry cluster research, focusing on owning the attractive clusters and avoiding the rest. Flexibility is also key to Select Industries’ long-term outperformance.
AdvantageHedge relies on a bi-weekly review we run to identify the weakest stocks within a vast liquid universe. The approach takes small positions and uses a rules-based approach, essential in managing a short position. This hedging allows us to hold the stocks we believe in, while reducing market exposure without realizing excess capital gains.
Horz: Are there any major misconceptions about tactical asset allocations that need to be addressed? Can you address these issues and put them into proper perspective?
Muller: We think it’s far too easy to dismiss all tactical asset allocators as market timers. Certainly in this space there are a number of managers who have failed to add value and they tend not to survive for long. Often these approaches have a simple discipline with binary decision making.
From the start of our strategy, we have integrated a mix of quantitative, technical and fundamental disciplines with the belief that, taken together, they are more effective over time than individually. We are never completely inside or outside the market. We use a 30% to 70% equity range, so our tactical decisions are where to fall within that range and which sub-asset classes are best positioned to gain that exposure at any given time. We’re not trying to make all-or-nothing decisions. In fact, one of the hallmarks of our process is lower return volatility, not extreme results.
Horz: Having been an early pioneer of tactical asset allocation, has there been any changes and evolution in the way the strategy has developed over time? What differentiators have you developed in your tactical strategies?
Muller: As mentioned earlier, our Major Trends Index was created in the 1970s, but this weekly pattern uses several factors, some of which have changed or disappeared over time. For example, data reported by the government has changed over the past 50 years, so we have to adapt.
We continually strive to improve the performance of our sub-strategies. We have made improvements to Select Industries and AdvantHedge over the years, but the DNA of the mandates has remained the same. Our focus on industry groups, while remaining independent of market capitalization and style, is a clear differentiator.
Our short approach is another clear differentiator; our hedging strategy for risk taking. While other TAA strategies hedge, many tend to use futures, options, or indices.
Horz: Why did you decide to create both mutual funds and ETF vehicles for your investment strategies?
Muller: Our Core strategy was created in 1987. At that time, we only offered Core as a separate account for institutions and high net worth individuals. Driven by demand for independent registered investment advisers, we created a no-load, no-load 12b-1 mutual fund in 1995.
The RIA universe has evolved considerably over the past 20 years and today many prefer the tax efficiency and often lower costs associated with the ETF structure. We were encouraged to build an ETF version of Core for many years, but wanted to make sure we were confident in our ability to replicate general mutual fund exposures without sacrificing performance. Once we were able to familiarize ourselves with our ability to effectively manage an ETF, we launched the vehicle in early January 2020.
Horz: How do you recommend advisors use tactical asset allocation in their clients’ portfolios? How can it be used to respond to the current market environment?
Muller: Advisors use our tactical asset allocation strategy in several different ways. Most often, we are used in an alternative pocket, either as a defensive equity allocation or as a hedged equity allocation. We offer diversification within the portfolio with long-term equity-like returns and much lower volatility.
We are also used as a swing manager within a more strategically balanced 60/40 portfolio. We sit between fixed income managers and equity managers and adjust exposures on margin, so the advisor doesn’t need to make changes. The environment we find ourselves in today is an ideal scenario for this type of application. Maintaining a 40% fixed income allocation should continue to be a headwind for the foreseeable future. If you can reduce this exposure, without removing an allocation from your preferred bond manager, this should ultimately help performance.
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