Tactical Asset Allocation vs Active Fund Management

Posted by InvestmentPro on March 6th, 2018

There is a belief, held by many investors, that investing in the best actively managed mutual funds will assure investment success. I seem to get into one of these discussions with investors and financial advisors every few months and each has a fresh list of actively managed funds which out-perform lower cost index funds. Since I am always looking for new ideas, I crank up my Tactical Asset Allocation Strategy Model and put the fresh list to the test. I have been disappointed each time I have done so. My most recent discussion on the subject prompted me to construct a blog post around the subject of actively managed funds.

Selecting A Basket Of Actively Managed Funds

I’m going to start with a fresh list of the best actively managed funds compiled by Morningstar. Morningstar says of these managers: “The 2015 awards marks the 29th year Morningstar has bestowed the honor on the managers that the Chicago-based fund research firm says deliver impressive performance, excellent long-term risk-adjusted returns, and exhibit “tremendous skill” in their field.”. The most recent list available is based on rankings through the end of 2015. We’ll take the top-rated fund in each of the five asset classes listed:

• Domestic Stock - Brown Capital Management Small Company (BCSIX - retail)
• International Stock - American Funds New Perspective (ANWPX - retail)
• Fixed Income - PIMCO Short-Term Fund (PTSHX - Institutional million minimum)
• Allocation - Vanguard Wellesley Income Fund (VWINX - retail)
• Alternatives - Vanguard Market Neutral (VMNIX - Institutional, million minimum)

Average fund fees for the basket run 0.83%. This looks like a solid group of funds with decades of performance and significantly lower than average bear market drawdowns. My basic modeling runs indicate that this basket performs better than any list I’ve previously tested. Finally, the basket does not stray terribly far from the traditional 60/40 equity/bond mix when coupling PIMCO Short Term Fund with Vanguard Wellesley Income Fund which, according to Vanguard’s description, holds 64% in Investment Grade bonds.

Comparisons to Tactical Asset Allocation

We are going to conduct three comparisons:

• How well does the M* Active Management basket perform on its own during a complete market cycle?
• Can basket performance be improved by employing basic Tactical Asset Allocation ("Tactically Enhanced")?
• How does performance of the actively managed basket compare to our own Global Core Tactical Asset Allocation Strategy?

We will measure Compound Annual Growth Rate, Maximum Daily Drawdown, and Standard Deviation (volatility). We will use these simple rules:

• Each test run will cover one (2007 - 2016) or two (2000 - 2007 and 2007 - 2016) complete market cycles
• Each fund in the M* basket will be maintained at equal weight on a Buy and Hold basis
• The Tactically Enhanced M* basket will be rebalanced monthly to include the best performing 3 of the 5 funds and may hold cash in lieu of holding funds which are performing negatively
• The TAAS Global Core Strategy (average ETF fees of 0.28%), which relies on index based ETFs, is limited to the 2007 through 2016 period only because the ETFs used were not all available for two full market cycles.

Two full market cycles

The first set of comparisons encompasses two full market cycles beginning with the top of the Bull market in April 2000 through the 2001-2002 Bear, the 2003-2007 Bull, the 2008 Bear, and the 2009-2016 Bull.

In the pure M* Best Active Managers basket, Brown Capital Management Small Company delivered the highest total return while Vanguard Wellesley Income Fund delivered the highest risk adjusted total return. The maximum drawdown occurred during the second bear market cycle.

The Tactically Enhanced version gave up 5% of return in exchange for a 38% reduction in drawdowns while making good use of its ability to move to cash. This portfolio took its maximum drawdown during the first bear market cycle.

One full cycle (September 2007 through August 2016)

The second set of comparisons encompasses one full market cycle beginning with the top of the Bull market in September 2007, the 2008 Bear, and the 2009-2016 Bull.

The M* Best Active Managers basket produced almost identical returns for the 2007 - 2016 period as for the entire 2000 - 2016 period which indicates reasonably consistent performance.

The Tactically Enhanced version delivered 20% higher return and 46% reduction in drawdown. Once again, this portfolio made good use of its ability to go to cash.

The Global Core Tactical Asset Allocation Strategy handily outperformed the M* Best Active Managers basket across the board with a 82% increase in Compound Annual Growth Rate, 72% reduction in Maximum Drawdown, and 19% reduction in Standard Deviation. And take note of the fact that this performance was achieved with a smaller equity component and higher fixed income component.

Concluding thoughts

The five funds in the M* Best Active Managers basket have 5.4 billion in Assets Under Management generating 1 million in fees paid by investors. I think we can assume that the top managers running these funds are collectively among the best paid portfolio managers in the world and have, at their disposal, the very best and most sophisticated of investment tools.

Is Active Management worth the cost? I think that the results of this test suggest that it is not. In short, these portfolio managers should be the creme de la creme of the financial services industry, yet this body of highly paid managers are handily beaten by a well-designed mechanical Tactical Asset Allocation strategy.