Theory versus Practice

September 13, 2011

I saw this cartoon on Greg Mankiw’s blog.  Whether it’s efficient markets, modern portfolio theory, or economic stimulus, economists haven’t had much luck with their theories lately!  The way in which supply and demand moves prices is usually a better indicator of reality than whatever the underlying economic theory is.    

(Click to enlarge)  Source: gocomics.com/Wiley Ink

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Tactical Asset Allocation on the Rise

September 13, 2011

So says a survey from Jefferson National, discussed in a recent article in Financial Planning:

As registered investment advisors and fee-based advisers are challenged by increasing market volatility and declines, they are turning to alternative investment classes and tactical allocation to protect their clients’ portfolios.

Roughly 50% said they have increased their use of alternatives, and 76% believe tactical asset allocation can outperform a passive approach over the long term.

Alternative assets are neither intrinsically good or bad.  Typically they increase diversification, but that can also come at the cost of reduced returns.  And assets that are uncorrelated now can certainly become correlated later, occasionally with very inconvenient timing.

Tactical asset allocation, if done in a very disciplined fashion, can certainly be beneficial.  Whether it outperforms a passive approach, however, can sometimes be dependent on where you are in the market cycle—and how you have constructed your tactical model.  A great deal of forethought and experience is required to build a tactical approach that will thrive in a wide range of market environments.

We love tactical asset allocation—we act as sub-advisors for two very successful global allocation funds for Arrow Funds—but the last decade has been very comfortable for anyone with the ability to diversify out of US equities.

Here’s my word of caution: advisors are gravitating toward tactical asset allocation now, maybe partly because it has done well for the last five to ten years.  When you choose a core fund for global allocation, think carefully about whether its approach is adaptive enough to handle strong equity markets.  True, we haven’t seen that for a while and the way things are going in Europe makes even the possibility seem remote, but that’s often when black swans surprise us.

Source: commons.wikimedia.org

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Relative Strength Spread

September 13, 2011

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 9/12/2011:

RS leaders and laggards have had similar performance for over two years now.  However, the RS Spread has been rising in recent months.  A meaningful breakout could bode well for relative strength strategies in the coming years.

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