Tactical allocation vs static indexing: which one wins?

Posted by Robin Powell on November 12, 2021

Tactical allocation vs static indexing: which one wins?



Tactical asset allocation sounds like a great idea. What’s not to like about a fund that switches between different asset classes in response to changing economic conditions? Well, the higher cost is a big drawback. But most investors wouldn’t mind paying that premium if they thought they could rely on the fund in question to deliver good returns in the long run. The question is, does tactical allocation actually work? Or are you better off with a static allocation to suitable low-cost index funds? LARRY SWEDROE reports on the latest research.



Tactical asset allocation, or TAA, is an investment strategy that varies the proportion of assets held depending on predictions based on either technical and/or fundamental analysis concerning returns in the short run. In other words, it’s a fancy term (allowing fund sponsors to charge high fees) for market timing.

Tactical allocation funds gained popularity during the financial crisis of 2008-09, as many investors sought downside protection. Wall Street met that demand, with asset managers launching more than 100 tactical allocation funds in the U.S. between 2009 and 2015, and assets under management in the funds increasing more than fourfold, from $19 billion in February 2008 to $87 billion in April 2013. Were investors, or just the fund sponsors, beneficiaries of this trend?


Is it a winning strategy?

Srinidhi Kanuri, James Malm and D.K. Malhlotra, authors of the study Is Tactical Allocation a Winning Strategy? published in the Fall 2021 issue of The Journal of Index Investing, evaluated the absolute and risk-adjusted performance of tactical allocation mutual funds and benchmarked them to various benchmark indexes over the period January 1994-October 2016.

The researchers compared the performance of tactical allocation funds to the U.S. stock market (Russell 3000 Index), bond market (Barclays Aggregate Bond Index) and foreign stock market (FTSE All World Ex U.S. Index). They then formed two portfolios: (P1) 65% Russell 3000 Index/35% Barclays Aggregate Bond Index and (P2) 45% Russell 3000 Index/20% FTSE All World Ex U.S. Index/25% Barclays Aggregate Bond Index/10% foreign bonds (Citigroup World Government Bond Index).

Following is a summary of their findings:

  • Tactical allocation funds had an average expense ratio of 1.39% (they are very expensive) and an average turnover of 289% (trading costs are high and tax efficiency is low).
  • TAA funds on average had about 49% of their assets in U.S. equity, about 33% in bonds, about 15% in foreign equities, about 8% in foreign bonds and about 13% in cash.
  • TAA funds underperformed all benchmark indexes and had lower absolute and risk-adjusted performance. The average TAA fund had cumulative returns of 215% versus 486% for P1 and 406% for P2. They even underperformed the Barclays Aggregate Bond Index, which returned 242%.
  • TAA funds produced an average Sharpe ratio of just 0.10 versus 0.17 for P1 and 0.15 for P2. Their Sortino ratio (a measure of downside risk) was also much lower, at 0.14 versus 0.25 for P1 and 0.22 for P2. 
  • Benchmarked against a seven-factor asset pricing model (the four Fama-French-Carhart factors of beta, size, value and momentum plus factors for foreign equities and domestic and international bonds), TAA funds had a highly significant (t-stat = 4.6) negative monthly alpha of -0.16 over the entire period. The negative monthly alpha was even worse, at -0.20% (t-stat = 5.2), over the period beginning in 2004.
  • TAA funds failed when needed most, during the Great Financial Crisis — over the period 10/2007-3/2009, they produced a negative monthly alpha of -0.37% (t-stat = 2.7). 


Investors “better off with passive funds”

Their findings led Kanuri, Malm and Malhlotra to conclude: “Our findings indicate that tactical allocation funds did not outperform the benchmarks, and investors would have been better off with passively managed funds that followed benchmark indexes.” 

Their findings are consistent with those of Joseph McCarthy and Edward Tower, authors of the study Static Indexing Beats Tactical Asset Allocation, published in The Journal of Index Investing Spring/Summer 2021. They found that tactical allocation funds had higher expense ratios, higher turnover than static index funds and produced lower returns while experiencing higher return fluctuations than their corresponding benchmark index funds. Portfolios of equally weighted TAA funds underperformed corresponding portfolios of index ETFs by 1.8% to 5.2% per year, and corresponding Fama-French benchmarks by 1.9% to 5.1% per year — the underperformance was well in excess of the expense ratios of the TAA funds.


Investor takeaway

As of October 2016, a total of 111 tactical allocation funds with $65 billion in assets were attempting to deliver better absolute or risk-adjusted returns than static allocation funds by deftly switching exposure among asset classes. Unfortunately for their investors, using Kanuri, Malm and Malhlotra’s finding of a negative monthly alpha of -0.16%, tactical allocation funds were subtracting value of about $1.25 billion a year. And their annual alpha of -1.92% was significantly higher than their average expense ratio of 1.39%. Thus, lower fees would not have turned “a sow’s ear into a silk purse.”

The bottom line is that tactical allocation funds are just another in a long list of funds that Wall Street created to be sold but should never be bought. Sticking to a long-term strategic allocation is the prudent course. 


Important Disclosure: The content contained is for informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® and Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any state or federal agency has approved, confirmed the accuracy, or determined the adequacy of this article. LSR-21-159



Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.


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