Morningstar Advisor - February/March 2012 - (Page 28)

In Practice Tactical Funds Miss Their Chance By Jeffrey Ptak “Tactical allocation” funds have been attracting assets, but our updated study finds that performance leaves much to be desired. It was a little over a year ago that we examined the success of “tactical allocation” mutual funds (“Tactical Strategies Miss Their Mark,” October/November 2010 issue). Tactical funds, which have been around for years but enjoyed a burst of popularity after the financial crisis, typically eschew investing in a static mix of investments like a traditional balanced fund would. Instead, they rapidly shift between asset classes, often in following macroeconomic or trend-following strategies. Proponents argue that tactical allocation can be valuable in bear markets or amid heavy volatility given their flexibility, which helps them to sidestep trouble. However, our earlier research found that these 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. That said, our study only ran through July 2010. Since then, markets have been choppy and range-bound at times, a climate that one could argue is better suited to tactical funds. (Many such funds fared poorly in the wake of the crisis, when markets rebounded sharply.) In addition, a number of the funds that we examined had launched recently, leaving them with relatively short track records at the time we conducted our earlier study. More prosaically, these funds have continued to attract assets at an impressive clip: Based on Morningstar estimates, the 155 active tactical funds that we track gathered more than $10 billion in net new monies for the year to date through Nov. 30, 2011. For those reasons, we decided to update our research to incorporate more-recent performance and assess how well these funds have done of late. Our Peer Group Our Findings We found that very few tactical funds generated better risk-adjusted returns than Vanguard Balanced Index’s over the extended time period we studied. r Just nine of the 112 tactical funds that existed for the full 17-month period earned a higher Sharpe ratio than the Vanguard fund. r Only 27 of the funds had a smaller “maximum drawdown” than Vanguard Balanced Index, meaning that the clear majority suffered larger peak-to-trough declines (Exhibit 1). In short, our extended study found scant evidence that these funds delivered on their goal of delivering competitive returns with a smoother ride. Most gained less than the Vanguard fund, were more volatile and prone to downside, or both. This is consistent with our previous findings. To be fair, one could argue that the extended time period we studied really spanned three distinct markets—a continuing equity bull market (Aug. 1, 2010, to April 30, 2011), a sharp correction (May 1, 2011, to Aug. 21, 2011), and a renewed rally (Aug. 22, 2011, to Dec. 31, 2011). So, the question is whether these funds better distinguished themselves amid the spring and summer tumult, when downside avoidance was more important than upside capture. In our earlier study, we examined 163 tactical funds, including 39 that had previously been liquidated or merged out of existence. As of Dec. 31, 2011, that tally had risen to 210 funds, as fund companies launched a bevy of tactical strategies in the latter half of 2010 and throughout 2011. Our Study To extend our previous findings, we measured each tactical fund’s net annualized return, standard deviation, Sharpe ratio, and maximum drawdown from July 31, 2010, to Dec. 31, 2011. We then compared our findings with the results of Vanguard Balanced Index VBINX, which passively invests its assets in a 60%/40% stock/bond mix. (This extends the results of virtually every fund in our previous study, with the exception of 15 tactical funds that were merged or liquidated away since July 2010.) 28 Morningstar Advisor February/March 2012

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012