Swedroe: Tactical Approaches Miss The Mark

February 08, 2017

We can define “conventional wisdom” as ideas that have become so ingrained that few people ever question them. Millions of people believing in an idea, however, doesn’t make it true. Yes, conventional wisdom can be wrong. For example, at one time, millions of people believed the Earth was flat, and that the Earth was the center of the universe.

Time For Tactical?

In an article on InvestorPlace, headlined “3 Vanguard Funds That Are Taking on Water,” the author recommended that now was a good time for tactical investors to start selling shares of certain types of funds.

He went on to provide his logic specifically for recommending the sale of three of Vanguard’s mutual funds: “With an aging bull market that is much closer to the end than the beginning—and rising interest rates marking the mature phase of the business cycle—we can identify some specific areas of the market that investors will want to avoid … or at least minimize exposure.”

One of the three funds the author listed was Vanguard’s REIT Index Fund (VGSIX). His logic was based on the conventional wisdom that “mutual funds that hold interest-rate-sensitive stocks, such as real estate investment trusts, will likely fall behind the broad market indices in the short run. This makes Vanguard REIT Index Fund Investor Shares a likely underperformer to sell now.”

He added: “Like bonds, prices for REITs have historically had an inverse relationship with interest rates: When rates are low or falling, REITs generally perform best; when rates are rising, REITs typically underperform.”

Doing The Math

Let’s go to our trusty videotape to see how REITs actually performed during the worst period of rising rates in the postwar era. At the start of 1978, the three-month bill rate was at 6.4%. But by August 1981, it had reached 15.5%. During the period 1978 through 1981—the sharpest rise in short-term rates we have seen—the Dow Jones U.S. Select REIT Index provided an annualized return of 26.9%, far outperforming the S&P 500, which returned 12.3%.

Now, this negative relationship didn’t always hold true. However, if conventional wisdom and the author of this article were correct, we should see a positive relationship between the returns to fixed-income investments and REITs.

But, for the period 1978 through 2016, the annual correlation of returns to the Dow Jones U.S. Select REIT Index and the BofA Merrill Lynch 1-3 Year Treasury and Agency Index, the Five-Year Treasury Index, and the Bloomberg Barclays Long-Term US Treasury Bond Index were all actually slightly negative, at -0.03, -0.12 and -0.09, respectively. In other words, the correlations were effectively zero. So much for conventional wisdom, and the logic of the author’s recommendation.

 

Step Away From Passive Bond Funds?
The two other recommendations made in the article are also worth discussing. The first is that “a secular bear market for bonds is upon us and passive funds like Vanguard Long-Term Bond Index Fund Investor Shares (VBLTX) are not the best ideas to hold now.”

My first comment is that the evidence suggests there really aren’t any good interest rate forecasters, or at least any forecasters more likely to be correct than the collective wisdom of the market (which is embedded in current yields). In fact, the S&P Dow Jones Indices year-end 2015 active versus passive scorecard (SPIVA) showed that over the prior 10-year period, 96% of actively managed long-term government bond funds had underperformed their index. So much for the ability of active managers to outsmart the market by guessing at interest rates.

I would add that we heard the same warnings last year, and short-term Treasurys went on to underperform both intermediate- and long-term Treasurys in 2016. It’s also important to note that today’s yield curve is positively sloped, telling us that the market expects rates to rise. Thus, the only way one can benefit from staying short is if rates rise more than already expected.

Embrace Riskier Stocks?

The third recommendation was that “the mature phase of a business cycle is a good time to steer clear of the riskier stocks in the market, and this makes Vanguard Explorer Fund Investor Class (VEXPX) among the group of Vanguard funds to avoid now.”

As I mentioned earlier, the overwhelming evidence demonstrates that very few actively managed funds have been able to outperform by shifting allocations, or tactically allocating, as suggested. In fact, the evidence on tactically allocating funds isn’t a pretty picture.

For example, Morningstar once examined the returns of 163 tactical asset allocation (TAA) funds covering the period ending July 2010. It’s important to note that, by the close of the period, 39 of the funds no longer existed (because of merger or liquidation). Of the surviving tactical strategies, the median life span was 37 months as of July 31, 2010. That study found that TAA funds generally failed to deliver better risk-adjusted returns, or downside protection, than a traditional balanced index portfolio split 60/40 between stocks and bonds, respectively.

For example, 64 of the 92 (70%) TAA funds that at the time were at least a year old had worse since-inception performance than the passively managed Vanguard Balanced Index Fund (VBINX), with the average underperformance being 2.6 percentage points per year.

Morningstar later updated the study through the end of 2011. They compared the returns of TAA funds to VBINX, which passively invests its assets in a 60/40 stock/bond mix. Following is a summary of their conclusions:

 

  • Very few TAA funds generated better risk-adjusted returns than VBINX.
  • Just nine of the 112 TAA funds in existence over the period August 2010 through December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns).
  • Only 27 of the funds experienced a smaller maximum drawdown (the majority experienced larger peak-to-trough declines).
  • As of the end of the period studied, only 14 of 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring/summer 2010 correction and the European debt-related downtown soon after. In other words, just 17% of them consistently provided the insurance investors were paying for.

Maybe Not …

Keep these results in mind the next time you are tempted to tactically asset allocate. The bottom line: big fees, poor results. Put another way, TAA is just another game in which the winners are the product purveyors, not the investors.

I believe articles like this should be filed under the category that author Jane Bryant Quinn referred to as “investment porn”: “Americans are indulging themselves in investment porn. Shameless stories about performance tickle our prurient financial interest…. Mainline magazines (like Money, Smart Money, and Worth) … rarely descend to hard-core porn. That is what you get from the greedy gurus on cable TV, or the cruising shysters on the Internet. … We in the quality-media crowd specialize in soft-core porn. … The porn test isn’t the headline, but whether the story is anchored in reality.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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