How to Pick a Tactical Manager? | Tactical Investment Insights 07-22-2014

How to Pick a Tactical Manager?

Tactical asset allocation (TAA) has come back in fashion recently. Investors were stung, badly, by the financial crisis of 2008. No one wants to go through an experience like that again, which has led to renewed interest in TAA. A new group of tactical managers called ETF strategists has emerged to meet the demand from investment advisors and investors. ETF strategists normally use ETFs heavily to make their tactical bets. According to Morningstar, there were 660 ETF strategies from 151 firms with $103 billion asset under management as of Q1, 2014.

TAA is nothing new and has been around for decades. Its objective is simple: a tactical manager has the flexibility to move quickly among different asset classes so the manager can participate in market upside while limiting the downside risks. Instead of picking the best stocks like traditional mutual fund managers, tactical managers are trying to identify the best time to get in and out of broad asset classes like stocks and bonds based on some black-box algorithm or fundamental judgment.

Market timing is not an easy task. In 1994, John R. Graham and Campbell R. Harvey published a research paper analyzing the market-timing ability from newsletters. ” We analyze the advice contained in a sample of 237 investment letters over the 1980-1992 period. Each newsletter recommends a mix of equity and cash. We construct portfolios based on these recommendations and find that only a small number of the newsletters appear to have higher average returns than a buy-and-hold portfolio constructed to have the same variance.”

Some of the ETF strategists did deliver some degrees of downside protection in the last decade during the last two bear markets. However, the recent performance of some big tactical ETF managers has been disappointing. Investors have started to realize that not all tactical managers are the same. Picking a good tactical manager is the key to investment success. As a tactical asset manager ourselves, we like to offer some insiders’ advice to investors as follows:

 (1) Understand the theory behind the “secret sauce”
Any reasonable TAA model needs to have strong economic and financial theoretical foundation. Without a strong theory, the model is just a “data-mining” exercise, which has little chance of success in the long run.
(2) Back test needs to cover various market cycles.
Many tactical managers do not have long-term track records, instead they show back test performance. The drawbacks of the back test such as data-fitting and hindsight benefits are well understood. However, some managers only back test their model for 5 years or 10 years. Those results are insufficient to show the legitimacy of the model. Investors need to see the model perform over a few market cycles and understand when the model outperformed and when the model underperformed.
(3) Team experience
Many tactical managers, especially some ETF strategists, have come to the market without long term investment management experiences. Although they may be brilliant in developing quantitative models, they may face some difficulties when market conditions start to change and the model under-performs. To build long-term success, the TAA models need to continuously improve and adapt to ever-changing market conditions. Experience will be important in those efforts.
(4) Track record
 Long-term track record is important in evaluating a tactical manager. Good long-term record is an indication of the manager’s past success. As we all know, the past performance is not indication of future results, especially in the tactical management space. There are numerous examples of once-hugely successful managers who had to close their funds. Investors should evaluate the performance record in the context of managers’ investment models, philosophy and edges.

(5) Sales organization vs. research organization
Some asset management firms build successful businesses with extensive sales efforts even though their investment performance is mediocre. Investors should try to avoid those firms, and instead invest with the firms who allocate more resources to research and portfolio management. In the end, it is  the in-depth research capability that will help a tactical manager to deliver superior returns in the long run.