How passive becomes active

Index ETFs are building blocks for tactical asset allocation. But does it work?

Paul Kaplan 10 March, 2015 | 5:00PM
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Note: This article is part of Morningstar's March 2015 ETF Investing Week special report.

Most exchange-traded funds are passive investments designed to replicate market-cap-weighted indexes. But these ETFs can also serve as components of portfolios that are very much actively managed.

The most active of these approaches is tactical asset allocation. It has the same starting point as strategic asset allocation, in that both start off with a mix of asset classes. The proportions allocated to each asset class are based on the managers' views on the expected returns and risks of each asset class, and the degree to which the returns of each pair of asset classes tend to move together.

The key difference between the tactical and strategic approaches is that in strategic asset allocation, the investor or portfolio manager selects a set of asset-class weights based on a long-term view of future risks and returns. Unless these views are updated, the portfolio is regularly rebalanced back to the strategic weights. For example, if we were using a stock ETF, a bond ETF and a money-market fund, our strategic asset allocation could be 60% stocks, 30% bonds and 10% cash.

By contrast, tactical asset allocators make shifts in response to changes in the managers' short-term views. For example, if a tactical allocator believed that stock returns, relative to the returns on bonds and cash, are likely to be higher over the short term than over the long run, the allocator would reduce the bond and cash allocations and increase the stock allocation. This would leave the portfolio with a more aggressive mix, such as 70% stocks, 25% bonds and 5% cash.

Tactical asset allocation makes sense if two conditions hold:

  1. The portfolio manager does not believe that active management at the asset-class level would achieve superior performance. For equity markets, this means a belief that attempting to pick individual stocks is futile.

  2. The portfolio manager believes that it is possible to forecast with some accuracy the returns of asset classes over short periods, at least relative to each other. Managers who employ tactical asset allocation often make these forecasts using macroeconomic variables such as GDP growth, inflation, growth in the money supply, exchange rates, interest rates and changes in the price of oil.

But do these conditions make sense? Years ago, the financial economist Richard Grinold formulated the "fundamental law of active management," which suggests that the level of skill needed to successfully pick stocks is less than that needed to successfully practise tactical asset allocation.

Specifically, the fundamental law states that an active manager's risk-adjusted value added is the product of the manager's skill and the square root of the number of independent decisions that the manager makes. Since a stock picker has numerous opportunities to place independent decisions and a tactical asset allocator only has far fewer, the argument is that a tactical asset allocator would need far more skill than a successful stock picker to be as successful.

For example, suppose that a stock picker is selecting and weighting stocks from a large enough market to have the opportunity to make 900 independent decisions per quarter. Let's also suppose that a tactical asset allocator has enough asset classes, each represented by an ETF, to make nine independent decisions per quarter.

To apply the fundamental law to both managers, we multiply the square root of 900 (30) by the skill level of the stock picker, and the square root of 9 (3) by the skill level of the tactical asset allocator. In order for the tactical asset allocator to be as successful as the stock picker, he or she needs 10 times the skill!

But is this true? Not surprisingly, some tactical asset allocators have been critical of using the fundamental law in this way to argue against what they practice. A good example of this criticism is in an article by Max Darnell and Ken Ferguson of First Quadrant titled Thoughts on Grinold & Kahn's Fundamental Law of Active Management. (Because Ronald Kahn has co-authored a book and articles with Grinold, the fundamental law is associated with him as well.) First Quadrant is a California-based asset management firm that employs tactical asset allocation.

One point that Darnell and Ferguson make is regarding the impact of transaction costs on the number of independent decisions that a manager can make. Transaction costs, they say, play a very significant role in determining manager success. "They are not only a cost which offsets the profits obtained from trading on a successful forecast, but they also significantly reduce the universe of bets that the manager will take. These are issues that can, and very often do, turn a skillful manager into a failed manager."

The low costs of trading ETFs work to the advantage of tactical asset allocators who use them to represent asset classes.

Darnell and Ferguson also contend that there are fewer independent decisions in stock picking and more in asset allocation than you might think. The correlations of market indexes, they say, are lower than the correlations of stocks within an index. In other words, the returns on individual stocks are less independent than the market indexes that represent the asset classes and are implemented as ETFs.

I do not completely buy this argument. It all depends on which stocks and which market indexes we are talking about. I suspect that the correlation between the returns of large-cap and small-cap Canadian stock indices is higher that the correlation of the returns of most pairs of Canadian stocks. If there is to be any advantage to tactical asset allocation, the asset classes need to be quite independent of each other.

Finally, it's important to realize that tactical asset allocation is usually a contrarian strategy. In other words, as asset classes rise and fall in value relative to each other, the allocations move in the opposite directions. For example, after a rise in stock prices without a rise in bond prices, a tactical asset allocator typically moves money from stocks to bonds. (Strategic asset allocators do this as well, but not to the same degree.)

Therefore, in order for tactical asset allocation to add value over holding asset classes in proportion to their market values, there must be investors willing to do the opposite of what the tactical allocators are doing. In other words, there must be "willing losers" who take the opposite side of these trades.  That won't necessarily be the case.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.

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