Global Tactical Asset Allocation:
Just the Facts, Part 1

We recently came across a couple of articles making the sensational claim that TAA is nothing more than a repackaged and dressed-up version of market timing. Both articles – and others, we’ve subsequently learned – point to a Morningstar study showing that TAA has underperformed the Vanguard U.S. 60/40 balanced fund over the past few years. We have several problems with the original study and the referencing posts, but it all boils down to these points of difference:

  • TAA is still widely misunderstood by many investors and advisors;
  • TAA does not require discretionary market calls, and is best implimented by harnessing timeless and pervasive market factors like value and momentum;
  • It is silly to benchmark most TAA strategies against a domestically focused stock/bond benchmark, such as a balanced fund.

We will cover the first two points in this article, and address the other two points in subsequent missives. For those who want to jump ahead and read our comprehensive position at GestaltU, the post can be found here.

For starters, tactical strategies do not require discretionary market calls. Good thing, too, since there is no evidence that investment experts are able to make accurate discretionary calls on market direction, interest rates, earnings, margins, or any other factor that determines investment returns using economic models, traditional technical analysis, or macro narratives. In fact, research suggests that discretionary managers as a whole would be better off employing a random decision process, since at least it would short-circuit the cognitive biases which cause them to do the wrong things at the wrong time.

Fortunately, rather than relying on expert market forecasts, the best tactical strategies rely on timeless and persistent market truths that provide a statistically significant edge. For the same reason we can be confident that stocks will always beat cash over the long-run, we can expect certain truths to persist because they are based on rational approaches to risk, the rate of information diffusion, and immutable emotional biases rooted in the very fabric of the human experience.

So what are these truths? The first truth is that cheap markets outperform expensive markets over the next 1-5 years. The second truth is that if markets have been going up recently, they are more likely to go up again tomorrow (and over the next few weeks). In finance parlance, these truths are called ‘value’ and ‘momentum’ effects, and they have been observed in virtually every market since the dawn of time.

You’re probably wondering, “If these effects are so strong and pervasive, why doesn’t everyone use them?” In fact, you may be surprised to learn that the largest and most sophisticated institutions in the world – such as the proprietary trading desks of large banks, national pension plans, and sovereign wealth funds – have moved a substantial portion of portfolios into strategies that systematically harvest these effects. It’s particularly notable that they have diverted these funds from traditional discretionary strategies.

But the reason you may not have heard about these truths is because the existence of the asset management industry rests squarely on the false premise that the unique insights, talents, and knowledge of ‘experts’ is required in order for you succeed. Unfortunately, there is no evidence that these discretionary experts actually can help anyone succeed, as they consistently fail to outperform simple indexes, in terms of either lower risk or higher returns.

To paraphrase the great Bill Bernstein, there are three kinds of professionals in markets:

  • Those who don’t know they can’t predict the market;
  • Those who know they don’t know; and,
  • Those who know they don’t know, but whose job depends on maintaining the illusion that they do know.

Unfortunately, the financial industry is overwhelmingly dominated by those in the former and latter categories. That is, most financial professionals are either under the illusion that they have special talents or knowledge that will allow them to outperform, and/or they have suspended disbelief in order to make a living. There was a time when we belonged in the first category, but a combination of experience and overwhelming evidence changed our minds after 2008.

For these reasons, we stay away from discretionary strategies of any kind, including discretionary tactical strategies based on so-called expert insights performing traditional financial analysis. However, thousands of hours of proprietary research and dozens of papers over the past few decades have convinced us that systematic strategies, which focus on harvesting timeless factors like value and momentum, can outperform traditional indexes over the long-term.

In a recent paper, Asness, Moskowitz and Pedersen performed extensive tests of the momentum and value factors on a wide variety of securities and asset classes. Their results should obviate any doubts about the power of value and momentum in global markets.

Figure 1 below shows a summary table from the paper with some key statistics. At the risk of getting nerdy for a moment, please note the numbers inside the red box. In particular the ’t-stat’ is a measure of statistical significance; any absolute t-stat above 3 (that is, either <-3 or >+3) suggests that there is less than 1% chance that the observed results were due to random chance. In fact, the t-scores we observe on the value and momentum factors in Figure 1. are close to 5, implying a 1 in 10 million chance of a spurious relationship. In short, momentum and value exist – in fact they are probably the most significant and persistent dynamics observed in markets.

Figure 1. Statistical evidence for value and momentum effects across global markets

 Source: Asness, Moskowitz, Pedersen, Value and Momentum Everywhere

In summary, while the evidence is clear that no one can successfully forecast market turns, this fact is unrelated to the potential of GTAA. Rather, the key to successful Global Tactical Asset Allocation is to rely on proven factors by systematically biasing portfolios toward the cheapest or highest momentum sectors of global markets. So long as risk is risk, and people are people strategies founded on these reliable principles will continue to deliver.

Disclaimer

Confidential and proprietary information. The contents hereof may not be reproduced or disseminated without the express written permission of ReSolve Asset Management Inc. (“ReSolve”). ReSolve is registered as an investment fund manager in Ontario and Newfoundland and Labrador, and as a portfolio manager and exempt market dealer in Ontario, Alberta, British Columbia and Newfoundland and Labrador.
These materials do not purport to be exhaustive and although the particulars contained herein were obtained from sources ReSolve believes are reliable, ReSolve does not guarantee their accuracy or completeness. The contents hereof does not constitute an offer to sell or a solicitation of interest to purchase any securities or investment advisory services in any jurisdiction in which such offer or solicitation is not authorized.

Forward-Looking Information. The contents hereof may contain “forward-looking information” within the meaning of the Securities Act (Ontario) and equivalent legislation in other provinces and territories. Because such forward-looking information involves risks and uncertainties, actual performance results may differ materially from any expectations, projections or predictions made or implicated in such forward-looking information. Prospective investors are therefore cautioned not to place undue reliance on such forward-looking statements. In addition, in considering any prior performance information contained herein, prospective investors should bear in mind that past results are not necessarily indicative of future results, and there can be no assurance that results comparable to those discussed herein will be achieved. The contents hereof speaks as of the date hereof and neither ReSolve nor any affiliate or representative thereof assumes any obligation to provide subsequent revisions or updates to any historical or forward-looking information contained herein to reflect the occurrence of events and/or changes in circumstances after the date hereof.

General information regarding returns. Performance data prior to August, 2015 reflects the performance of accounts managed by Dundee Securities Ltd., which used the same investment decision makers, processes, objectives and strategies as ReSolve has used since it became registered and commenced operations in August, 2015. Records that document and support this past performance are available upon request. Performance is expressed in CAD, net of applicable management fees. Indicated returns of one year or more are annualized. Past performance is not indicative of future performance.

General information regarding the use of benchmarks. The indices listed have been selected for purposes of comparing performance with widely-known, broad-based benchmarks. Performance may or may not correlate to any of these indices and should not be considered as a proxy for any of these indices. The S&P/TSX Composite Index (Net TR) (“S&P TSX TR”) is the headline index and the principal broad market measure for the Canadian equity markets. The Standard & Poor’s 500 Composite Stock Price Index (“S&P 500”) is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy.

General information regarding hypothetical performance and simulated results. These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account or fund managed by ReSolve will or is likely to achieve profits or losses similar to those being shown. The results do not include other costs of managing a portfolio (such as custodial fees, legal, auditing, administrative or other professional fees). The contents hereof has not been reviewed or audited by an independent accountant or other independent testing firm. More detailed information regarding the manner in which the charts were calculated is available on request. Any actual fund or account that ReSolve manages will invest in different economic conditions, during periods with different volatility and in different securities than those incorporated in the hypothetical performance charts shown. There is no representation that any fund or account will perform as the hypothetical or other performance charts indicate.

General information regarding the simulation process. The systematic model used historical price data from Exchange Traded Funds (“ETFs”) representing the underlying asset classes in which it trades. Where ETF data was not available in earlier years, direct market data was used to create the trading signals. The hypothetical results shown are based on extensive models and calculations that are available for any potential investor to review before making a decision to invest.