Tactical Asset Allocation In The Age Of ETFs

August 16, 2016

by Henry Ma, Ph.D., CFA

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The financial crisis of 2007-2008 and the resulting deep bear market challenged conventional wisdoms as well as modern portfolio theory. Strategies such as buy-and-hold suffered significant drawdowns. Diversification did not provide enough protection as most asset classes became highly correlated. Fearing continued market volatility and subsequent downturns, investors searched for better risk-management alternatives.

Tactical asset allocation (TAA) strategies, which have the flexibility of allocating among different asset classes without any constraint, offered a promising solution.

Driven by investors’ demand, TAA experienced renewed interest after the financial crisis. A new class of TAA managers, who use ETFs extensively and are often referred to as “tactical ETF strategists,” emerged. As of December 2015, Morningstar tracked 271 tactical ETF strategies. Assets under management and the number of tactical ETF strategies, a subset of all ETF-managed portfolios (excluding hybrid and strategic strategies), tracked by Morningstar grew exponentially between 2011 and 2014. The total AUM/AUA reached $46 billion at the end of 2013 (see Figure 1), before declining to $26 billion at the end of last year.

Figure 1: AUM and Total Number of Tactical ETF Strategies*

Tactical Asset Allocation In The Age Of ETFs

Source: Morningstar. * The data does not include Strategic and Hybrid ETF strategies.

The post-crisis TAA strategies had some distinct characteristics as compared to the old-style TAA (see Table 1). Many emphasize downside protection and employ various flavors of trend-following or momentum approaches, which have proved to be the most effective ways for limiting downside losses by commodity trading advisors (CTAs) and global macro hedge funds. In addition, the new TAA strategies use ETFs extensively as they offer the ability to efficiently gain the desired market exposure after the tremendous growth of the ETF industry in last 20 years.

Table 1: Comparison of Tactical ETF Strategies with Old-style TAA

Tactical Asset Allocation In The Age Of ETFs

In recent years, two of the largest tactical ETF strategists (Ed. note: these were F-Squared Investments and Good Harbor Financial) struggled with some regulatory or performance issues. As a result, the tactical ETF strategies space experienced some asset outflows. However, the median tactical ETF strategy performed in line with investors’ expectations and limited the downside risks and provided diversification over the past 10 years.

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