An Investment Strategy that Reverse Engineers Its Benchmark

Beating investment benchmarks has been the bane of active managers’ existence. While many do, the SPIVA reports (S&P) document how a large cross-section of mutual funds underperform their index with the most recent 2021 year-end report stating 76.67% of U.S. mutual funds underperformed the S&P500. Many investment strategies have been developed to try to beat their benchmarks ranging from mirroring their index with 5-10% tactical tweaks in deemed under and over performing components of their index, to concentrated strategies that cherry pick the standout management teams or business models, to adding specific proprietary macroeconomic or other tactical overlays that dynamically alters the portfolio holdings in their chosen benchmark’s universe of stocks. Many aspects of the ongoing evolution and innovation in asset management lies in these continuing efforts.  

The Institute was recently introduced to an asset manager with a singular conviction to outperformance by employing a “clearinghouse” of investment strategies that were determined by reverse engineering their funds’ benchmarks. The key to this investment philosophy is flexibility by creating diversification by investment strategy, subadvisor managers, and a multiple time frame perspective selected based on the needs of each fund relative its index.

To explore this further, the Institute reached out to Drew Horter, President & CEO of Tactical Fund Advisors – a growing Cincinnati-based fund group providing risk-managed, multi-strategy mutual funds designed to dynamically adapt to changing market environments. In our discussion we wanted to better understand their investment strategy and the process behind reverse engineering an index or other benchmarks.

Hortz: How do you design an investment strategy to compete directly with its index or Morningstar category?

Horter: In developing the fund allocations, we start with a “core” strategy designed to compete directly with the benchmark or category. For this portion of the portfolio, we first determine the asset class breakdown of the category. 

For example, we know the Morningstar Moderate Target Risk Category allocates 59% to Equities, 40% to Fixed Income and 1% to Cash. Next, we look at the allocations to cap sizes and styles within each asset class for equities, as well as the allocations to Core, Short-, Intermediate and Long-term bonds, foreign bonds, REITs, TIPs, etc.

Armed with the allocations to the asset classes, cap size, style, and class sector data, we then build out our strategy holdings, which are tilted slightly to over/underweight the category allocations based on our macro view. In short, we strive to outperform the category making a converted efforts not to “reach” too far for alpha with this part of the portfolio. Our view is this approach acts as an excellent anchor to the portfolio. 

From there, we employ multiple strategies which are selected for their ability to deliver alpha, a targeted volatility range, appropriate upside and downside capture, as well as the correlation to the market, and other strategies within the fund. We then monitor performance on a daily basis as well as portfolio statistics for each strategy monthly.

Hortz: Can you break down further with specifics how you reverse engineered the benchmarks around some of your funds?

Horter: We currently manage four multi-manager TFA Tactical mutual funds. So let me focus on a few:

TFA Tactical Income Fund (TFAZX) – We began with an exhaustive examination of Morningstar’s top Non-Traditional Bond Funds benchmark category. We noted that even the best funds frequently move on and off the leaderboard. We attribute this phenomenon largely to singular strategies tied to specific investing approaches moving in and out of favor with changing market conditions. In response, we have designed an adaptive blending process utilizing multiple managers and strategies. The overall goal is to produce more consistent outcomes over a market cycle. Our unique quantitatively driven investment strategies build on a core of diversified bond ETFs, layering on blends of multiple econometric, trend-following, and mean-reversion approaches.

Econometric approaches weigh in on national economic health, matching the most historically favorable holdings to the current economic cycle. Trend following strategies work on the principal that recent trends will continue into the near future, while mean reversion strategies utilize the concept of prices being overbought or oversold. Many of the funds sub-strategies may also use levered or inverse ETFs to potentially enhance performance in differing market environments, including those that may otherwise be fundamentally unfavorable to fixed income.

All traded approaches may invest in the full spectrum of credit and duration ETFs, making the overall fund a go-anywhere tactical income approach. Allocations among the sub-strategies may further be dynamically adjusted according to their cross-correlation, relative trend and volatility characteristics using a proprietary mechanism, permitting the concentration of strategies to further adapt to evolving markets.

Finally, within the boundaries provided by Morningstar and the Morningstar Non-Traditional Bond Category, a maximum 15% allocation to hedged equity exposures is provided with the goal of further enhancing total fund returns while still targeting reduced downside risk and non-correlation appropriate to the fund category. This is designed to seek steady fixed income-focused returns featuring capital protective overlays and reduced interest rate correlation without the inherent risks of a singular manager approach.

TFA AlphaGen Growth Fund (TFAGX) - The portfolio development process for TFA AlphaGen Growth Fund began with an extensive analysis of Morningstar’s top Tactical Allocation Funds category. Once again, we found that even the top-rated funds frequently moved on and off the Morningstar leaderboard due to the fact that most funds employ a singular investing strategy which can fall in and out of favor as market conditions change. Our goals for the AlphaGen Growth Fund were to (1) create a more consistent return stream over a full market cycle, (2) afford the fund the ability to dynamically adapt to changing market regimes, (3) employ a globally diversified approach, and (3) build in risk mitigation techniques designed to preserve capital in nasty bear market environments.

The plan to achieve these mandates is based on our adaptive method of portfolio strategy blending employing multiple investment managers, multiple strategies, and multiple timeframes. This dynamic process quantitatively blends investment strategies. As such, when market conditions change, so too does the blend of investment managers and strategies utilized in the fund. The fund is built on a strategic aggressive core allocation reflecting an approximate 85/15 stocks versus bonds mix. From there, strategies employing stock selection, trend-following, relative strength, and mean-reversion approaches are blended to work as a single unit.

As stated in my previous fund discussion, many of the sub-strategies of this fund may also use levered or inverse ETFs to potentially enhance performance in differing market environments. Allocations among the sub-strategies may further be dynamically adjusted according to their cross-correlation, relative trend, and volatility characteristics using a proprietary mechanism, permitting the concentration of strategies to further adapt to evolving markets. In sum, the AlphaGen Growth Fund is designed to seek steady, global growth-oriented returns featuring capital protective overlays and reduced market correlation without the inherent risks of a singular manager approach.

Hortz: How do you keep these group of strategies working together to attempt to outperform the fund’s benchmarks?

Horter: In short, our clearinghouse approach affords the funds the ability to adjust their allocations to strategists, managers and signal providers without changing the prospectus. The concept here is similar to how a manager runs a baseball team. We too maintain a deep “bench” of managers and strategies that can be put into the lineup at any time and/or as conditions warrant. The approach is designed to stay true to the funds’ tactical objectives by keeping a group of strategies working together while allowing adjustments to strategy use over time.

Hortz: Can you tell us a little bit about the strategy behind some of your other funds?

Horter: To do a quick recap:

TFA Moderate Allocation fund (TFAUX) - As the name implies, the fund is an active, tactically risk-managed fund utilizing a 50-70% equity allocation and 30-50% fixed income. While continuing to employ multiple managers and multiple strategies, the central focus of the fund is now to outpace the comparative benchmarks using a quantitatively driven rotation methodology that allows the fund to invest in any combination of sectors or asset classes. A capital protective algorithm is used to potentially minimize loss in a market downturn by moving investments towards significant cash or cash equivalent positions. We believe this modernized diversification approach provides the best potential to achieve the portfolio's risk and return objectives.

The TFA Growth Allocation Fund (TFAFX) – in a similar fashion but more aggressively, our Growth Allocation portfolio Is an active, tactically risk-managed growth allocation fund utilizing a 70-90% equity allocation and 10-30% fixed income.. While continuing to employ multiple managers and multiple strategies, we recently added a 25% allocation to Howard Capital Management as a new sub-advisor to the fund specifically focused on alpha generation.

The TFA Quantitative Fund (TFAQX) – In January of 2022, the Quantitative Fund, which utilizes an aggressive, long-short approach, also became part of the multiple manager, multiple strategy, multiple timeframe “clearinghouse” fund lineup. Prior to the change, the fund had been managed using a single manager focusing on specific segments of the market. However, as the market environment evolved, the inherent limitations of a singular strategy became apparent. As such, we decided to add two managers and multiple investing strategies to the fund. As our most aggressively positioned growth fund, we felt it was important for the fund to have the ability to generate outperformance in differing market regimes.

Hortz: What about your other remaining fund? Does it employ a slightly different approach?

Horter: Our Multidimensional Tactical Fund (TFADX) is currently a single manager tactical fund. However, the manager of the fund does employ four different investment strategies in the fund. We view Multidimensional as our most risk-averse fund. In other words, it will move to risk-off in ANY of its positions very quickly. So, for those looking for a risk managed strategy with a quick trigger finger on the sell side, Multidimensional is the ticket.

Hortz: Any recommendations for advisors on how to apply your fund strategies to their clients’ portfolios?

Horter: Each of our actively risk-managed tactical funds is designed to fit a specific risk-targeted segment of client portfolio. Armed with the proper expectations, we believe that the funds can be an integral part of every investor’s portfolio looking for outperforming the indices and benchmarks with heightened risk and volatility management.

As an example, TFA Tactical Income Fund as a non-traditional, risk-managed bond fund was designed for fixed income investors as a diversifier to traditional fixed income funds. Our equity funds were designed as modernized approaches for investors seeking non-traditional, dynamic, risk-managed approaches to further diversify their portfolios.

Hortz: Any other thoughts you would like to share with advisors?

Horter: We would like to invite advisors to look at us as a resource and visit our Tactical Investing blog on our website where we share our research and thought leadership on this ever more important investment approach of tactical investing and how to apply it. While there on our website, please take a good look at our Tactical funds where a number of our funds are quickly approaching their 3-year mark and, due to performance, we have high expectations of strong Morningstar ratings.

Related: Bringing Personalization and Scale to Advisors Through Managed Accounts and Technology