Tactical Asset Allocation
March 3, 2009
Investors must take into account a few practical issues before putting these models to work in the real world: management fees, taxes, commissions, and slippage.
Expense ratios for the ETFs or mutual funds should be identical in the buy-and-hold and timing models, and they will vary depending on the instrument used for investing. Using ETFs and no-load mutual funds would cost approximately 20-100 basis points in fees.
Commissions should be minimal because of the model’s low turnover. On average, the investor would make 3-4 round-trip trades per year for the entire portfolio, and less than one round-trip trade per asset class per year. Slippage, the difference between the expected price of a trade and the actual execution price of the trade, likewise should be negligible, as there are numerous mutual funds (zero slippage) and liquid ETFs from which an investor can choose.
Taxes, on the other hand, are a very important consideration. Many institutional investors, like endowments and pension funds, enjoy tax-exempt status. Individuals can trade this system in a tax-deferred account like an IRA or a 401(k). Because different investors face different capital gains rates and tax rates vary across time, it is difficult to estimate the hit an investor would suffer trading this system in a taxable account. Most investors rebalance their holdings periodically — introducing some turnover to the portfolio — and it is reasonable to assume normal turnover of approximately 20%. The system has average turnover per year of almost 70%.
Gannon and Blum (2006) analyzed after-tax returns for individuals in the highest tax bracket who invested in the S&P 500. They estimate that an increase in turnover from 20-70% would have resulted in, approximately, an additional 50 basis point hit to after-tax performance, decreasing the results of the timing model for taxable investors.
There is a bright note, however, for those who have to trade this model in a taxable account. The nature of the system results in a high number of short-term capital gains losses and a large percentage of long-term capital gains, which might reduce the tax burden.
Conclusion
A simple-to-follow model can manage risk for an asset class and, consequently, for a portfolio of assets, with limited to no impact on returns. Since 1973, an investor could have increased his or her risk-adjusted returns by diversifying his assets and employing a market timing solution. In addition, the investor would have side-stepped many of the protracted bear markets in various asset classes. Avoiding these massive losses would have resulted in equity-like returns with bond-like volatility and drawdown, and over thirty five consecutive years of positive performance.
In Reminiscences of a Stock Operator, Jesse Livermore states, “A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does damage to the pocketbook and to the soul.”
References
Faber, Mebane T., A Quantitative Approach to Tactical Asset Allocation. Journal of Wealth Management, Spring 2007.
Gannon, Niall, and Michael Blum. “After Tax Returns on Stocks versus Bonds for the High Tax Bracket Investor”, The Journal of Wealth Management, Fall 2006.
Lefevre, Edwin. Reminiscences of a Stock Operator, Doran and Co., 1923.
Data
All data are total return series, and are updated monthly.
S&P 500 Index – A capitalization-weighted index of 500 stocks that is designed to mirror the performance of the United States economy. Total return series is provided by Global Financial Data and results pre-1971 are constructed by GFD. Data from 1900-1971 uses the S&P Composite Price Index and dividend yields supplied by Cowles Commission and from S&P itself.
MSCI Developed Market Index (EAFE) – A market-capitalization-weighted index that is comprised of 20 countries outside of North America. Total return series is provided by Morgan Stanley.
US Government 10-Year Bonds – Total return series is provided by Global Financial Data.
Goldman Sachs Commodity Index (GSCI) – Represents a diversified basket of commodity futures that is unlevered and long only. The returns include the collateral yield an investor would receive if invested in the index. Total return series is provided by Goldman Sachs.
National Association of Real Estate Investment Trusts (NAREIT) – An index that reflects the performance of publicly traded REITs. Total return series is provided by the NAREIT.
Mebane Faber is the Chief Investment Officer of Cambria Investment Management, Inc. where he manages quantitative investment funds. He is also the co-founder of AlphaClone and author of the upcoming book, The Ivy Portfolio. He writes the World Beta blog as well as publishing academic research. Mr. Faber graduated from the University of Virginia in 2000 with a double major in Engineering Science and Biology. Mr. Faber is a Chartered Alternative Investment Analyst (CAIA), and Chartered Market Technician (CMT).
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