Strategic vs. tactical: what's the difference?

Whether portfolio moves are temporary or long-term can help clarify the issue.

Adam Zoll 2 June, 2014 | 6:00PM

Question: I often hear the terms "strategic" and "tactical" used in regard to a fund's asset allocation, but I can't say I understand the difference. Can you explain?

Answer: Confusion over the terms "strategic" and "tactical" isn't confined to the world of investing. Although the terms' origins come from the battlefield, they are also used to describe actions in other competitive pursuits, including business, sports and games.

Merriam-Webster defines "strategic" as "of or relating to a general plan that is created to achieve a goal in war, politics, and so on, usually over a long period of time" and "tactical" as "of, relating to, or used for a specific plan that is created to achieve a particular goal in war, politics, and so on." The key distinction here is that the former refers to an overarching, long-term effort whereas the latter refers to a more specific action performed in the service of this larger strategic goal.

Allocation and opportunism

How does this distinction apply to investing? An investment strategy generally refers to a consistently executed long-term plan. For example, a mutual fund that routinely invests in stocks its managers believe are underpriced may be said to employ a value strategy. Or a bond fund that invests primarily in securities that pay above-average yields may be said to use a high-yield strategy. In fact, a fund's placement in a given CIFSC fund category often provides a good clue as to what a fund's strategy is. (The fund's name also may provide a clue, though one shouldn't rely on the name alone.)

As part of their strategies, some funds look for opportunities to improve performance by changing their investment mix more frequently than others, taking a so-called tactical approach. Such moves may be based on what the manager thinks is happening or will happen in the markets and typically are aimed at boosting gains, avoiding losses, or both.

Here are a few examples of moves that could be considered tactical:

  • An equity fund manager who believes that more speculative stocks may be falling out of favour rapidly shifts a substantial portion of his portfolio to more blue-chip names.
  • A bond fund manager who thinks bonds from a given country are temporarily underpriced reallocates assets in that direction.
  • An balanced fund manager, worried that a bear market is approaching, shifts a large chunk of assets from the equity side of the portfolio to the fixed-income side.

In Canada, balanced or asset allocation funds that use a tactical approach are classified in the appropriately named Tactical Balanced category. To be included in this category, a fund must have the flexibility to vary both its equity and fixed income components below 40% or above 60%, either as a provision in its prospectus or based on the fund's historical asset allocation tendencies.

For equity or bond funds there is no official line of demarcation between strategic and tactical investing, but the distinction between acting with a near-term and long-term mind-set is as good a guideline as any. A manager who opportunistically adjusts his fund's allocation based on what is likely a temporary change in the market is making a tactical move. One that makes such a shift with the intention of sticking with the new allocation for many years could be said to be making a strategic one.

Identifying tactical funds

Of course, some fund managers tactically reallocate assets more than others. There are managers who wouldn't dream of trying to time the market--which tactical investing is often likened to--while others see it as an essential part of their overall approach.

So how can you tell if the equity or bond fund you own employs a tactical approach? One obvious way is by reading the fund's prospectus to see if it mentions the fund's flexibility to shift assets around opportunistically. Another tell-tale sign is repeated dramatic changes in asset allocation during short time periods. For example, if you notice that the fund routinely shifts 10% of its assets from one sector to another, that may indicate its managers have a tactical mind-set. (Of course, given that some mutual funds may disclose portfolio data quarterly or semi-annually, it may be difficult to discern from this the degree to which a fund is tactical.)

Putting tactical to the test

But does tactical asset allocation work? Jeff Ptak, president of Morningstar Investment Management, has studied the topic and found that many so-called tactical-allocation funds fail to deliver on their promises of outsized gains and/or reduced volatility. In a 2012 study, he looked at the performance of U.S.-based funds that use tactical allocation and compared it to the performance of Vanguard Balanced Index, a fund that uses a static 60% stock, 40% bond allocation. He found that for the time period in question, July 2010 to December 2011, just nine of the 112 tactical funds that existed for the full period had better risk-adjusted returns than the Vanguard fund and that the majority experienced greater volatility.

Because they reflect the returns of tactical mutual funds rather than all tactical investment products (such as hedge funds and so forth), these results are by no means proof that tactical-allocation funds, or tactical approaches to investing, don't work. But the results do underscore the difficulty of shifting a fund's allocation in reaction to or in anticipation of market events, even for professional money managers.

Another important factor when considering tactical approaches is the potential to incur higher trading costs. A tactical fund will likely do more trading than a fund that takes a buy-and-hold approach, and executing all those trades can add to operational costs, weighing down fund performance. There's also the likelihood that the fund will incur more capital gains (or losses) as a result of its tactical moves, which could lead to higher tax bills for unitholders since it would lead to higher capital gains distributions, which are taxable at half the investor's marginal tax rate.

Owning a fund that invests tactically is not in and of itself a good or bad thing. The most important thing is that you understand how the fund operates and are prepared for the benefits and risks that come with this approach.

Have a personal finance question you'd like answered? Send it to AskTheExpert@morningstar.com.

About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com