Tactical asset allocation as an investment strategy has engendered both strong proponents and tough detractors over the years. We can see varying results when reviewing different time frames for performance, but then many investment styles have similar in-favor and out-of-favor periods. So, as proponents and detractors argue with each other, it needs to be noted that it might not be a matter of whether tactical asset allocation works or not, but what type of environment that you are in. With all the confusion and volatility in the markets today, it may be a good time to take a harder look at tactical investing.
As an example of a detractor’s position, last year Morningstar wrote a highly negative piece on Tactical Asset Allocation stating, “this investment strategy is notoriously difficult to implement in practice” and did not recommend the investment approach, to say the least. The article though did go on to qualify their opinion by acknowledging a few tactical managers that have been able to implement tactical approaches with a degree of success.
To get a different perspective, we reached out to the asset manager Morningstar positively cited as generating “some of the category’s best long-term returns by using a flexible approach to asset allocation”, the Leuthold Group - a Minneapolis-based market research and money management firm that recently became an Institute corporate member. We asked Leuthold Group’s co-CEO John Mueller questions to better understand tactical asset allocation, address misconceptions, and discuss the investment strategy’s unique place for today’s portfolios.
Hortz: Having been founded as an independent investment research firm providing original analysis for the institutional marketplace, why did you decide to form an investment management arm centered on tactical asset allocation and quantitative methodologies?
Mueller: The decision to apply the internal research and analysis into an investable portfolio was made prior to my joining the firm, but I know the story. Steve Leuthold was well known in the institutional research circles and frequently published his views on the market, allocation recommendations, and so on. The portfolio managers who subscribed to the research and had their performance measured daily, suggested that Steve should “put his money where his mouth was.”
They implied being a successful strategist and writing about calls was one thing, while implementing decisions in an investable portfolio was quite another. So, in 1987, the Core Investment Portfolio was born. Net equity exposure in the portfolio was dramatically underweight leading into the October crash, so Steve gained some credibility right out of the gates.
Hortz: How do you define what tactical asset allocation is and how do you go about implementing the strategy? What disciplines need to be in place to execute a tactical strategy that is not going to shoot you in the foot at the wrong time?
Mueller: We believe tactical asset allocation is primarily about flexibility. To properly execute a tactical strategy in different market environments requires the latitude of a broad opportunity set. Additionally, there is a certain level of nimbleness required to implement a flexible strategy. To effectively manage a tactical asset allocation strategy, being smaller and not capacity constrained is a huge advantage.
Lastly, it is our firm belief that you need to have processes in place intended to remove emotion and instill discipline. Our time-tested models have helped us to make tactical moves at times when it is difficult to do so, often going against the crowd.
Hortz: What are some of the different internal components or tools you use in your strategy that have been most effective?
Mueller: We have a number of sub-strategies and models we employee within our flagship Core strategy that have contributed to our long-term success. Beginning with our Major Trend Index (MTI) which we publish for our research clients on a weekly basis. This model is designed to gauge the overall health of the equity markets and helps us to position our portfolio to best reflect the current environment. The inception of the MTI dates back to the 1970s and while it has evolved over time, it still maintains its primary components.
Once we determine our desired net equity exposure, we manage it with a balance of our long equity strategy (Select Industries) and our short equity strategy (AdvantHedge). We have been managing both strategies successfully for decades.
Select Industries, as the name implies, leverages our monthly industry group research, focusing on owning the attractive groups and avoiding the rest. Flexibility is key to Select Industries’ long-term outperformance as well.
AdvantHedge leverages a bi-weekly screen we run to identify the weakest stocks within a broad, liquid universe. The approach takes small positions and utilizes a rules-based approach, critical in managing a short position. This hedge allows us to hold the equities we believe in, while reducing market exposure without realizing excess capital gains.
Hortz: Are there major misconceptions about tactical asset allocations that need to be addressed? Can you address these issues and put them into a proper perspective?
Mueller: We believe it is far too easy to dismiss all tactical asset allocators as market timers. Admittedly, within this space, there are a number of managers who have failed to add value and they do not tend to survive long. Often, these approaches have a simple discipline with binary decision- making.
From the inception of our strategy, we have incorporated a blend of quantitative, technical, and fundamental disciplines with the belief that, taken together, they are more effective over time than individually. We are never all in or all out of the market. We use a 30% to 70% equity band, so our tactical calls are where to be within that band, and what sub asset classes are best positioned to gain that exposure at any point in time. We are not trying to make all or nothing decisions. In fact, a feature of our process is lower volatility in returns, not extreme outcomes.
Hortz: Having been an early pioneer in tactical asset allocation, has there been changes and an evolution in how the strategy has been developing over time? What differentiators have you developed in your tactical strategies?
Mueller: As mentioned earlier, our Major Trend Index was created back in the 1970s, but this weekly model employs multiple factors, some of which have changed or gone away over time. For instance, reported data from the government has changed over the past 50 years, so we must adapt.
We continually strive to improve the performance of our sub-strategies. We have made enhancements 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 market cap and style agnostic, is a clear differentiator.
Our short approach is another clear differentiator; our hedging strategy for taking off risk. While other TAA strategies hedge, many tend to utilize futures, options, or indexes.
Hortz: Why did you decide to create both mutual funds and ETF vehicles for your investment strategies?
Mueller: Our Core strategy was created in 1987. At that time, we only offered Core as a separate account for institutions and HNW individuals. Driven by demand from independent Registered Investment Advisors, we created a no-load, no 12b-1 mutual fund in 1995.
The RIA universe has evolved substantially in the past 20 years and today many prefer the tax-efficiency and often lower costs associated with the ETF structure. We have been encouraged to create an ETF version of Core for many years, but we wanted to make sure we were confident in our ability to replicate the general exposures of the mutual fund without sacrificing performance. Once we were able to get comfortable with our ability to effectively manage an ETF, we launched the vehicle in early January of 2020.
Hortz: How do you advise or recommend that advisors can employ tactical asset allocation in their clients’ portfolios? How can it be used to address today’s market environment?
Mueller: Advisors use our tactical assets allocation strategy in a few different ways. Most often, we are used in an alternative bucket, either as a defensive equity or hedged equity allocation. We offer diversification within the portfolio with longer-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 the fixed income and equity managers and will adjust the exposures on the margin, so the advisor does not need to make changes. The environment we are in today is an ideal scenario for this type of application. Maintaining a 40% allocation to fixed income is likely to continue to be a headwind for the foreseeable future. If you can reduce that exposure, without taking an allocation away from your favorite bond manager, it should ultimately help performance.
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