How Tactical Asset Allocation Helps

This paper from Research Affiliates shows that many people time markets, without acknowledging it, and do so to their detriment. It develops several simple strategies for deciding how to tilt an investment portfolio of “smart beta” strategies and compares the results.

Selecting the three smart beta strategies with the best past performance would have cost the trend-chasing investor 30 basis points (bps) of value-add (1.2% versus 1.5%) compared to sticking with the average smart beta strategy through thick and thin. In the case of factors, the trend chaser loses half of the excess return (1.2% versus 2.4%) relative to the average factor. With the reduction in value-add comes an increase in risk because of the concentration in three (versus eight) strategies. Our smart beta trend chaser suffers a drop in information ratio from 0.34 to 0.25, and our factor trend chaser’s Sharpe ratio plummets from 0.52 to 0.14. Trend chasing, even sensibly using up to 10 years of history to choose our strategies, demonstrably destroys value, even as it increases risk.¹²

Now, let’s see how our contrarian investor fares. In the case of the smart beta strategies, the contrarian bests the trend chaser with a materially higher value-add (2.2% versus 1.2%) and an improved Sharpe ratio (0.34 versus 0.25), and also performs well against the equally weighted allocation in terms of value-add (2.2% versus 1.5%), while maintaining the same information ratio (0.34) despite less diversification. In factor investing, our contrarian investor has a slightly different result, earning a higher return (3.3% versus 1.2%) and Sharpe ratio (0.39 versus 0.14) compared to the trend chaser, but although value-add is higher (3.3% versus 2.4%) compared to the equally weighted portfolio, the Sharpe ratio is lower (0.39 versus 0.52) due to lower factor diversification and higher risk. The tradeoff between performance and Sharpe ratio will drive different decisions for different investors. For example, we would accept a small haircut in Sharpe ratio in order to earn a materially higher return.