By Rufus Rankin, Director of Research
As equity markets move downward, it is natural to ask how Tactical Asset Allocation is positioned, and whether TAA is adding value as most asset classes lose value.
Rather than highlight a particular TAA model we use, I think it makes more sense to use the very basic model presented by Mebane Faber in his 2007 paper, “A Quantitative Approach to Tactical Asset Allocation.” This simple model uses five asset classes and a single trend-following rule to manage a portfolio. It has been out in the public eye for more than a decade, and can serve as a simple benchmark for understanding more complicated portfolios and strategies.
The model uses five asset classes: US Stocks, Foreign Developed Stocks, US Treasury Bonds, US Real Estate and Commodities. Each asset receives an equal weight allocation, or 20%, and the following ETFs are used: SPY, EFA, IEF, VNQ, GSG.
The model uses a single parameter, the 10 month simple moving average (“SMA”) of prices, to decide whether to be long an asset, or in cash. If an asset’s price ends a month above the 10 month SMA, then you buy or keep an allocation to that asset for the next month. If the price ends the month below the SMA, then you sell that asset and go to cash for the next month, or stay in cash if you were already “flat”. The model rebalances monthly.
Our simple model has generated slightly higher returns than an equal weight portfolio, with roughly 40% lower volatility and less than half the maximum drawdown. We can clearly see in the chart that the model has reduced the large drawdowns of 2008 and 2020 by going to cash. The model trailed the equal weight portfolio a bit after the crash or correction of Q1 2020, but is now ahead again.
It is easy to understand this performance. When an individual asset looks like it is entering a drawdown, the model sells the asset and goes to cash, which can reduce exposure to large negative returns. NB: we can invest in a cash equivalent with a bit of yield if we so choose. While not perfect, and subject to a bit of miss-timing sometimes (see the quick recovery in 2020, for example), on average this simple model has the portfolio out of harm’s way during large drawdowns and bear markets. As of now (May 2022), the model is “Flat” US Stocks, Foreign Stocks, US Bonds and US Real Estate, and “Long” Commodities.
If risky assets continue to go down, the model will stay flat, possibly earning a small yield in T-bills. When stocks and other assets return to a positive trend, the model will buy again, hopefully having sat out most of the turmoil. There may be a bit of back and forth as the market decides on a new direction, which means the model may buy, then sell, then buy a few times, and may lag a long-only portfolio if there is a quick recovery, but on the bright side we can enjoy a much calmer and less volatile portfolio.
TAA can help reduce the risk of large drawdowns during bear markets, by rotating out of assets that appear to be entering drawdowns. The downside is that the TAA portfolio can lag a bit during roaring bull markets. While not perfect, TAA can help preserve capital through time, which is of great value to long-term investors.
|Performance 2007 – Present|
6/29/2007 – 5/23/2022
Faber, Meb, A Quantitative Approach to Tactical Asset Allocation (February 1, 2013). The Journal of Wealth Management, Spring 2007 , Available at SSRN: https://ssrn.com/abstract=962461
- ETFs used for illustration are SPY, IEF, EFA, VNQ, GSG
- Data source: Yahoo! Finance
- No cash asset is used, so returns could potentially be higher if a safe asset with modest yield received “flat” allocations