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 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.
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