Flies in the TAA Ointment
Despite the fact that most tactical asset allocation (TAA) models have fallen on mediocre times over the last couple of years (1), I’m still mostly positive about the concept, mainly because the core principles of most of these models (trend-following, momentum, etc) have worked across mature markets for generations.
Having said that, there are some flies in the ointment for TAA moving forward that are rarely fully embraced, but will make these models less effective in the future.
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The most critical of these is the little potential upside still left in US Treasuries and other low-risk fixed income assets, and all of the problems that necessarily leads to.
If yields increased from a higher baseline (like Treasuries in the 1970’s), bond funds (which tend to maintain a somewhat constant maturity) could still be a long-term source of return, because today’s coupon makes up for some of the price change resulting from increasing yields.
But that’s not as much the case today with yields so low (see estimates of the hypothetical upside still remaining in 10Y UST). An increase in yields today would have a much more negative impact on bond funds, ETPs, etc.
Treasuries can still serve to reduce volatility in the portfolio (because Treasuries exhibit low to negative correlation with equities), but if it fails to be a source of return (or worse, a drag on returns) TAA will suffer.
That problem is made worse by the fact that correlation across most major asset classes has been increasing in recent years. No longer are international or emerging market indices, or individual (developed) markets, or private equity, or real estate, or commodities strong diversifiers of equity risk.
The only other major asset class that still acts as a strong counterweight to these equity-like investments, is gold and precious metals (and equities + gold do not a diversified portfolio make).
In short, over the long-term: without Treasuries, TAA volatility will rise, but with Treasuries, returns will fall.
Any attempt to reach for higher yields (ex. corporate bonds) is just going to increase the portfolio’s correlation with equities, et al. (especially during market shocks), and therefore increase portfolio volatility.
None of the above ramblings are new information, I’m just thinking aloud.
And lest I sound like Chicken Little, let me say that there’s still some juice left in Treasuries, so this problem doesn’t necessarily kick in tomorrow. And even without Treasuries, there’s clearly value in using trend-following, momentum, etc.
My point is that (despite the fact that TAA and all of its sophisticated alternatives have become all the rage as of late) there isn’t enough talk about the realities of a future where traders’ most significant source of returns that are uncorrelated with equities fails to deliver.
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I’ve reached my self-imposed word limit.
This subject is important to me. I’ve always been successful at building strategies to generate big aggressive (but volatile) returns, but I often struggle with a low-vol, “sleep well at night” home for the core of my wealth.
In a follow up post I’ll share my own thoughts on solving this problem.
(1) Of course, I’m referring to real-time, out-of-sample TAA models (i.e. the only kind that really matter), not the backtested variety burning up the blogosphere.
P.S. on further thought, I left out currencies as a major asset class w/ the potential to diversify equity risk. I haven’t seen much juice from currencies in any of the TAA models I follow, but I’ll throw it out there.
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Filed under: Tactical Asset Allocation | 22 Comments