The life of equity fund managers is becoming increasingly difficult. Many active managers had realized decades ago that it was difficult to create outperformance, so they changed their strategy to essentially provide index-like performance. There is much less career risk for a fund manager if the performance is more or less like the benchmark. A generation of index-huggers was thus born.
However, benchmarks have become investable with the rise of ETFs, and offering benchmark-like products with higher fees has become less acceptable. Capital allocators began calculating the active share of mutual funds and challenging fund managers with low shares. Be active or go, this is the new motto.
Assessing stock market-focused fund managers is relatively easy given obvious benchmarks like the S&P 500. Ideally, fund managers consistently outperform their benchmark. However, evaluating tactical asset allocation ETFs is more difficult as there are no clearly defined benchmarks.
Additionally, the lines between strategic and tactical asset allocation often blur. There is little justification for charging high fees for strategic asset allocation, as investors themselves can replicate this effectively.
In this research note, we will evaluate a framework for identifying tactical asset allocation (TAA) strategies.
Assessment of tactical asset allocation strategies
TAA strategies invest dynamically in all asset classes. Many focus only on stocks and bonds, while others also include REITs, currencies and commodities. A managed futures strategy, also called CTA, which takes long or short positions in hundreds of asset classes, is the ultimate version.
We focus on TAA strategies that are available through ETFs traded on the US stock market and have a track record of at least three years. The resulting universe includes 15 ETFs that manage just over $1 billion in assets and charge an average management fee of 0.92% per year, compared to nearly 0% for an S&P 500 ETF.
We will use a portfolio comprised of the S&P 500 and US investment grade bonds (60/40 portfolio) as our benchmark portfolio and measure the extent to which TAA managers deviate from this portfolio. If they are more active, measured by betas from regression analysis, then the high management fees might be justified as they at least have the potential to create value.
For example, we can compare the betas of the iShares Core Growth Allocation (AOR) ETF, which is an approximation of a 60/40 portfolio, and the Arrow DWA Tactical ETF (DWAT) to the S&P 500 in the period between 2015 and 2022 Analysis highlights that the beta of AOR against the US stock market was almost always between 0.5 and 0.6, compared to a much wider range between 0.1 and 0, 7 for DWAT.
Naturally, this underscores that DWAT is indeed tactically allocating and had low equity exposure when equity markets were deemed unfavorable by its managers. Its stock beta has steadily declined, which is likely due to the fact that the ETF not only has exposure to US equities, but also to emerging and international markets.