WHITE PAPER

February 2015
For professional investors

The Case for Tactical

Asset Allocation

Newfound Research LLC

425 Boylston St.
3rd Floor
Boston, MA 02116

617-531-9773
www.thinknewfound.com
info@thinknewfound.com

Many factors result in investment returns that differ from the

academic view of long-run averages.

Diversification is not the free lunch it is often made out to

be; return generators are often replaced by risk mitigators in
an asset allocation scheme.

Decreasing bond return potential and increasing global asset

correlations makes diversification potentially costlier and less
effective simultaneously.

By smoothing out volatility (and the emotional reaction to it),

tactical asset allocation may enable investors to carry more
risk generating assets within their portfolio, which can lead to
increased total return over their investment lifecycle.

Newfound Research LLC | The Case for Tactical Asset Allocation

Is the Long Run Just Too Long?

Jeremy Siegels Stocks for the Long Run is one of the first resources to
put hard numerical evidence behind the conventional wisdom of buy
and hold. Going back as far as 1802, the author calculates that equity
markets have achieved a long-run average real return of 6.5 to 7
percent.
While that compounding rate is certainly compelling, the critical capital
allocation decisions of individual investors are not made over the long
run. Many factors result in investment returns that differ from the
academic view of long-run averages, such as:

A 40 year, or less, investment horizon for the typical individual

Dynamic investment contributions & income growth
Changing savings rates (5.7% at age 25 to 9.3% at age 551)
Shifting risk preferences as investors age
Dynamic liabilities (e.g., educations, mortgages, cars)

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1. How America Saves,

Vanguard, 2008.

These variables mean that the order of market returns is perhaps more
important than the long-term average in determining investment
outcomes. In the short-term, markets can, and will be turbulent: The
annual returns for the S&P 500 Index, on average, differ from the longrun average by 14%. The result? An historical 27% probability that $1
invested in the S&P 500 Index would be worth less than $1, in realterms, ten years later. For example, in the graph below, we can see that
$1 invested in almost anytime from 1965 1973 stood a good chance
of being worth less than $1 a decade later. These are material risks that
can steer everyday investors off-course. Nor do they even account for
the emotional turmoil (and thus worse decision making) caused by
market volatility.

Newfound Research LLC | The Case for Tactical Asset Allocation

Newfound Research LLC

425 Boylston St.
3rd Floor
Boston, MA 02116

Rolling 10-Year Annualized S&P 500 InflationAdjusted Total Return

This graph plots annualized
inflation-adjusted total returns for
the S&P 500 over rolling 10-year
periods. We see that when an
investor invests can be critical in
determining her financial future.

Long-Term 1-Year Return Average

The traditional remedy for these concerns has been diversification, but
as we will see in the next section, the concept on its own is by no
means a panacea.

Diversification: Not Quite a Free Lunch

It was not until Harry Markowitzs work in the 1950s, which eventually
coalesced into Modern Portfolio Theory, that the concepts of
diversification were mathematically defined. Slide-rules aside, the
concept of diversification can be succinctly explained: dont put all
your eggs in one basket. In investing, that means allocating capital to
multiple asset classes to reduce idiosyncratic risk. The magic behind
diversification and one of the reasons it is considered to be the only
free lunch available in the marketplace is that a portfolio of assets
will always have a risk level less-than-or-equal-to the riskiest asset
within the portfolio.
A combination of assets, therefore, can help reduce an investors
deviation from long-run return averages. One view of asset classes is to
break them down into high return, but riskier, return generators (e.g.
stocks) and safer, but lower returning, risk mitigators (e.g. bonds). A
combination of such assets would, ideally, allow investors to meet their
financial objectives within their risk tolerances.

Newfound Research LLC | The Case for Tactical Asset Allocation

One of the benefits of diversification is that a portfolio combination of

return generators and risk mitigators can often provide an attractively
asymmetric tradeoff in the reduction of total return versus the reduction
of portfolio risk. We can see this in long-run average annualized return
and volatility numbers for the S&P 500, 10-Year constant maturity U.S.
Treasuries, and a 60/40 portfolio of both.
Annualized Return & Volatility (9/1981 - 10/2013)
18%
16%

The difference in annualized

return between the S&P 500 and
a 60/40 portfolio is the
premium paid (due to holding
lower-returning bonds) to achieve
the greatly reduced annualized
volatility.

14%
12%
10%
8%
6%
4%
2%
0%
Annualized Return
S&P 500

Annualized Volatility

10-Year U.S. Treasuries

60/40

To achieve the reduction in risk, a premium has to be paid from the

annualized return (a premium that will be highly dependent on future
bond returns). However, the premium paid for the risk reduction is
much lower than the premium paid had we simply purchased only
bonds, making the diversification exercise a compelling risk-reduction
tool.
Diversification as an Insurance Policy
Diversification is not dissimilar to buying fire or flood insurance for a
home: an insurance premium is paid to protect against losses. If the
risks are never realized we have paid a premium for naught.
Using Monte Carlo techniques, we estimate that the S&P 500 Index
suffers a drawdown in excess of 30% on average only once every 10
years; consider this event our flood or our fire. The return-reducing
effect of risk mitigators in a well-diversified portfolio is, therefore, like

Newfound Research LLC | The Case for Tactical Asset Allocation

paying an insurance premium for ten years for one year of protection. In
the long run, the thesis of diversification is that the asymmetric trade-off
between premium paid versus risk mitigation works out in the favor of
long-term total return.
From this perspective and at this point in market history, there are three
primary issues facing diversification going forward.
1) The Premium is Getting More Expensive
One of the unique realities of the last 20 years has been the bull
market in U.S. Treasuries due to declining interest rates. This
trend has created an environment whereby our risk mitigator was
also a tremendous return generator. This made a 60/40 portfolio
an incredibly attractive investment profile.
However, this reality was not always the case. Older investors
will remember a very different interest rate environment whereby
the use of the risk mitigator within the portfolio came with a hefty
premium. From 1963 to late 1981, a constant maturity index of
10-year U.S. Treasuries had an annualized loss of 3.15%.
Diversification was certainly not free.
Annualized Return & Volatility (1/1963 - 9/1981)
16%
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%

The premium paid for risk

reduction varies depending on
macro-economic conditions;
during the rising rate environment
from 1963-1981, bonds
generated a negative real return,
making them a costly diversifier
to hold.

Annualized Return
S&P 500

Annualized Volatility

10-Year U.S. Treasuries

60/40

While there is no guarantee that rates will necessarily rise

imminently, they do sit near long-term historical lows and are
Newfound Research LLC | The Case for Tactical Asset Allocation

unlikely to go much lower. As current bond yields are great

predictors of long-term fixed-income returns, the returngenerating ability of bonds may be stifled over the next decade.
As such, we believe it makes sense to consider other
methodologies to manage risk within a portfolio.

10-Year Annualized Treasury Return

18%
With a few simplifying
assumptions, it can be
demonstrated that the expected
return of a constant-maturity
bond index is equal to current
on-the-run bond yields; we see
this theoretical relationship play
out in the high degree of
correlation between the starting
period bond yields and forward
10-year annualized returns for 10year U.S. Treasuries.

16%
14%
12%
10%
8%
6%
4%
2%
0%
0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Beginning Bond Yield

2) Sizing the Policy is Difficult

The archetypal balanced portfolio, a 60/40 split between stocks
and bonds, has been a stalwart of portfolio construction for
several decades. However, it is difficult to find any references as
to where the concept for the 60/40 originated.
The 60/40 portfolio appears to have originated from Markowitzs
concept of the market portfolio, a theoretical marketcapitalization-weighted portfolio of all investable assets, worldwide. In the 1950s, the U.S. equity market had a total
capitalization of approximately $5T and the bond market had a
total notional value of approximately $4T. Since then, the ratio
has reversed, the total U.S. equity market capitalization
exceeding $18T and the bond market approaching $40T, placing
the new ratio closer to 30/70.

Newfound Research LLC | The Case for Tactical Asset Allocation

So while the original 60/40 may have been founded on solid,

albeit theoretical, ground, the staying power of the 60/40
portfolio may have been more due to its ease of implementation
and marketability. Consider how well it fit with common sense
investing sound bites, such as own your age in bonds.
The problem with the 60/40 portfolio is that an asset allocation is
not a consistent risk profile. Nevertheless, we have effectively
sized our insurance policy as if it were. By plotting the realized,
rolling quarterly volatility profile of a 60/40 portfolio, we can
clearly see that the risk profile of the portfolio is anything but
stable over time.
Trailing 63-Day Annualized Volatility for a 60/40
Portfolio
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%

3) The Payoff is Uncertain

Unlike insurance, diversification is not guaranteed. In other
words, the macro-economic environment may be such that our
risk mitigators become sensitive to the risks we are trying to
protect against. For example, stocks and bonds are likely to both
be positively correlated to inflation shocks. Or, quite simply, we
might have the wrong risk mitigators in our portfolio for the
prevailing risk in the market place.

Newfound Research LLC | The Case for Tactical Asset Allocation

From a mathematical perspective, diversification is often

measured through correlation, a statistical metric that measures
the similarity of movement between asset classes. Over the last
Trailing 1-Year Average Cross-Correlation of 14
Global Stock Indices
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

Increasing correlations can

reduce the effectiveness of
diversification. The graph, left,
plots the average crosscorrelation between 14 global
equity market indices. Since
1993, correlations have risen
from less than 30% to, at peak,
near 90%.

several decades, cross-geographic and cross asset-class

correlations have been on the rise, reducing the efficacy of
diversification (in the sense of adding additional asset classes) as
a risk management tool in a portfolio. The rise in correlations has
been blamed on both macro-economic factors (e.g. globalization)
and micro-market factors (e.g. indexing) alike.
Furthermore, correlation is difficult to estimate because most
estimates rely on purely historical data. Correlations are not
stable over time, meaning that constructing a portfolio policy
based on historical correlations can leave us unprotected or
over-protected from certain risks going forward.

What is Tactical Asset Allocation?

At a high level, tactical asset allocation (TAA) is a dynamic investment
strategy that actively reallocates capital based on prevailing macroeconomic themes, seeking to under-allocate to unfavorable asset
classes and over-allocate to favorable ones. In more recent years,
tactical solutions have heavily focused on capital protection where the
target outcome is not too dissimilar to diversification. The difference lies
in the process utilized to achieve the outcome: instead of constantly

Newfound Research LLC | The Case for Tactical Asset Allocation

utilizing risk mitigators within the portfolio, a TAA methodology will

frequently re-evaluate the macro-economic environment to determine
when to selectively add risk mitigators into the portfolio.
Tactical Asset Allocation as an Insurance Policy
Similar to diversification, the de-risking capabilities of a TAA strategy
can be evaluated in the context of an insurance policy. Where
diversification is akin to holding both fire and flood insurance, a tactical
solution is more similar to buying short-term fire insurance when it looks
like a fire is likely and short-term flood insurance when a flood is likely. If
the tactical model is correct in its macro analysis, it can
opportunistically de-risk the portfolio exposures to protect capital and
re-risk to participate in market growth. If the model is incorrect and derisks the portfolio unnecessarily, a premium is paid in the form of
trading costs and whipsaw (the losses from buying high and selling low
or missed opportunity costs from selling low and buying high).
While it comes with its own costs, the utilization of tactical strategies
can provide solutions for the three problems facing diversification that
we outlined above.
1) Expensive Premium? = Shop the Policy
The cost of incorporating traditional risk mitigators into a portfolio
may become more expensive for investors in coming years.
Fortunately, tactical asset allocation strategies look to only
selectively apply these risk mitigators.
Furthermore, in
unconstrained strategies, each emerging macro-economic trend
can be evaluated independently and the most effective, lowestcost risk mitigator can be deployed. So while a diversified
solution looks to carry insurance policies for all risks, tactical
solutions look to selectively apply policies for only the most
prevalent risks. This difference can dramatically reduce total
return drag within the portfolio.
2) Policy Sizing = Intuitive
With diversification, it can be difficult to determine the
appropriate allocation to risk mitigators to create a consistent
risk profile. Allocations to tactical solutions can be quite intuitive:
the tactical allocation sleeve of a portfolio should be sized such
that it never exceeds the lower or upper allocation bounds for
any asset class.

Newfound Research LLC | The Case for Tactical Asset Allocation

Consider an investor with a strategic 60/40 portfolio willing to

vary her allocations within the range of 20/80 and 80/20. The
tactical solution she wishes to employ is completely
unconstrained and can range between 0/100 and 100/0. By
reconfiguring her portfolio to now be 40% stocks, 20% bonds
and 40% tactical, she has a flexible solution that will vary within
the allocation limits she feels comfortable with.
3) Payoff Still Uncertain = BUT Potentially Better Together
Unfortunately, similar to diversification, the defensive benefits of
a tactical solution are not guaranteed. However, strategic
approaches and tactical solutions are by no means mutually
exclusive within a portfolio. In fact, we advocate for the
incorporation of both within an investors portfolio for the benefit
of process diversification.

Conclusion
While a well-diversified, strategic asset allocation should serve as the
basis for any investors investment policy, current economic and market
conditions may lead to the decreased effectiveness of diversification as
a risk mitigation tool. Low, and potentially rising, interest rates make
traditional diversifiers expensive, and rising and unstable correlations
mean that a static allocation is less likely to deliver a consistent risk
profile. We believe that a tactical asset allocation approach that can
dynamically react to emerging risks in the market can supplement
traditional versions of diversification and deliver a more consistent risk
profile. By smoothing out volatility (and the emotional reaction to it),
TAA may enable investors to carry more risk generating assets within
their portfolio, which can lead to increased total return over their
investment lifecycle.

Newfound Research LLC | The Case for Tactical Asset Allocation

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For more information about Newfound

Research call us at +1-617-531-9773,
visit us at www.thinknewfound.com or
e-mail us at info@thinknewfound.com
Past performance is no guarantee of future returns.
IMPORTANT: The projections or other information generated
by Newfound Research LLC regarding the likelihood of various
investment outcomes are hypothetical in nature, do not reflect
actual investment results, and are not guarantees of future
results.
All investing is subject to risk, including the possible loss of the
money you invest. Diversification does not ensure a profit or
protect against a loss. There is no guarantee that any particular
asset allocation or mix of funds will meet your investment
objectives or provide you with a given level of income.
These materials represent an assessment of the market
environment at specific points in time and are intended neither to
be a guarantee of future events nor as a primary basis for
investment decisions. The performance results should not be
construed as advice meeting the particular needs of any investor.
Neither the information presented nor any opinion expressed
herein constitutes a solicitation for the purchase or sale of any
security. Past performance is not indicative of future
performance and investments in equity securities do present risk
of loss. Newfound Research LLCs results are historical and their
ability to repeat could be affected by material market or
economic conditions, among other things.

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