market folly

Thanks to a reader for bringing this back to our attention. Today we want to highlight an intriguing research piece from back in 2006 from index-fund giant Vanguard. Back then, they put out an interesting white paper on evaluating tactical strategies entitled, "A Primer on Tactical Asset Allocation." The fact that they would publish such a thing in the first place speaks volumes as they could possibly perceive a threat to their bread and butter business of low-cost buy and hold index investing. And while the piece was written nearly 3 years ago, it becomes all the more interesting given the events that have transpired since its publication.

The adage of 'buy and hold' has come into question with the recent jaw-dropping market declines of 2008 and many investors are re-evaluating their strategies and methodologies. As such, talk of other strategies (including tactical asset allocation) has begun to pick up and the argument has intensified.

While we highly doubt Vanguard would ever openly admit they perceive this to be a threat, it is curious. Did they publish a 'cautionary advocacy' paper in an attempt to cut this argument off at the pass? It almost seems as if they published such a piece because they were beginning to feel some heat. The question now is, has that heat intensified? We'll have to look around to see if they've released any follow-ups or additional research on the subject matter given the rough year the indexes had in 2008. While it's only natural for Vanguard to come defend their turf, this debate could very well be just beginning and could wage on for many years.

The introduction to the paper reads as follows,

"Many pension funds, endowment funds, and other institutional investors are concerned that equities - typically their largest asset allocation - will have lower average returns over the next decade. In this environment, many investors have questioned the wisdom of thinking about asset allocation solely in strategic terms and have shown renewed interest in tactical approaches.

Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiences or temporary imbalances in equilibrium values among different asset or subasset classes. Over time, strategic long-term target allocations are the most important determinant of total return for a broadly diversified portfolio. TAA can add value at the margin, if designed with the appropriate rigor to overcome significant risk factors and obstacles unique to the strategy. Our results show that while some TAA strategies have added value, on average TAA strategies have not produced statistically significant excess returns over all time periods."

Interesting premise indeed. They then go on to address these issues in a 12-page white paper where they examine tactical asset allocation and the pros & cons. In the end, their paper then concludes the following: "As we have highlighted, consistently predicting systematic risk is challenging at many levels. SAA is the critical decision, while a well-designed TAA strategy can add value at the margin. However, successful TAA requires rigorous methodology. Understanding the TAA investment process, using quantitative performance-evaluation metrics to distinguish luck from skill, and minimizing costs are essential to the success of TAA strategies."

Embedded below is the entire Vanguard presentation:



Alternatively, you can download the .pdf here.

In the end, we're sure this isn't the last we'll hear of this discussion/debate and we look forward to further research to be presented by both sides of the argument. While Vanguard wouldn't openly admit that they are wary of a threat, we certainly see how this paper could be perceived as such... especially now.

For more reading on the subject, we highly suggest checking out various resources from Mebane Faber. In particular, his book The Ivy Portfolio details the endowment model of investing and even examines hedge fund portfolios, much like we do here at Market Folly on a daily basis (see our review of the book here). Additionally, Mebane covers various strategies on his well-known blog World Beta. Lastly, he is also a portfolio manager at Cambria Investment Management and co-founder of Alphaclone, a hedge fund replication tool we have used extensively to create the Market Folly custom portfolio that since January 2000 has seen a total return of 878.3%, annualized returns of 26.1%, and Alpha of 23.4.