Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Buy-and-hold will never die.

And yet, and yet. The monstrous volatility that has visited global stock markets over the last two decades has given rise to an alternative investing mantra: buy-and-adjust.

As my Bloomberg colleague Mohamed El-Erian noted, a more flexible approach to asset allocation may allow investors to exploit volatility by tilting their portfolios to cheaper assets during market selloffs and to higher quality assets during booms.    

Which begs the question: Has a flexible (tactical) approach to asset allocation -- in which an investor opportunistically adds value plays to her portfolio when markets are whipsawing -- beaten a static (buy-and-hold) approach to asset allocation?

To figure that out, I compared the average returns of flexible allocation mutual funds with those of static allocation mutual funds. And, indeed, flexible funds beat static funds by 0.4 percent annually from 2001 to 2015 (the longest period for which data is available; those returns include dividends).

Slip Slidin'
The percentage of flexible allocation funds that have beaten static allocation funds has fallen off in recent years.
SOURCE: Morningstar

Actually, flexible funds did even better than that. The expense ratio for a flexible fund is 0.4 percent higher on average than that of a static fund. If you take this spread in fees into account, flexible funds beat static funds by 0.8 percent annually from 2001 to 2015. Not too shabby.  

The success of flexible funds over the last 15 years should not be surprising. In essence, flexible asset allocation is a classic value play, and the value premium is widely acknowledged.

Yes, managers more commonly attempt to harvest the value premium through individual security selection, but why should the value premium be any less effective as applied to asset allocation?

But investors who hope to capture this flexible allocation premium will have to do more than just show up to the market and begin window-shopping.

For starters, flexible allocation doesn’t always work. It requires volatile markets, of course. It also requires that markets return to their senses before exasperated investors give up. Flexible allocators are betting that cheap assets will recover and that expensive assets will deflate (in geek speak, this is known as "mean reversion").

Today, for example, a savvy flexible allocator may tilt her portfolio to energy-related assets, but if energy totally collapses or takes 30 years to recover -- which is effectively the same thing when it comes to investing -- well, that would not be good. These essential ingredients for success -- volatility and mean reversion -- have been largely missing from markets over the last five years. Instead, markets have been mostly calm and winners have continued to win while losers have been further beaten up. Just look at investors’ continuing preference for growth stocks over value stocks or U.S. stocks over international and emerging stocks

The numbers support this: Flexible funds lost to static funds by 2.2 percent in 2015, by 2.2 percent annually over three years, and by 1.2 percent annually over five years.

Tough Times
After a string of wins, flexible allocation funds have lost to static allocation funds for five consecutive years.
SOURCE: Morningstar

Investors hoping to capture the fruits of flexible allocation may have to endure extended periods of under-performance when the strategy is out of favor.

An abundance of flexible funds makes selecting a manager tricky. Flexible allocation is to some extent a skill-based game, and I suspect that managers of copycat funds are less skilled than managers of the pioneering funds who preceded them.

Further complicating the task of choosing a manager and fund is the increasingly diverse group of strategies that fall under the flexible allocation banner, including Global Tactical Asset Allocation, Global Macro, Risk Parity, and other yet unnamed strategies. These are distinct strategies that can behave differently in different environments. Fund categories are not yet sophisticated enough to distinguish among them, but investors will have to.

Still, unless you think that volatility and mean reversion belong in the dustbin of history, there is good reason to believe that flexible allocation will shine again. The fact that the environment has been hostile to flexible allocation over the last five years may mean that a cyclical turn is coming, and the recent uptick in volatility may be just the spark.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net