Tactical Asset Allocation for Passive Investors

If there was ever a market made for tactical asset allocation, it would be the market we have now, right?

Not that many years ago, we all knew which way the market was going: up, up, and up. The bull market for stocks that started in the early 1980s seemed endless.

A lot depends on where you start counting and where you stop, but in general the Dow returned well over 16% a year, compounding annually, from mid-1982 through 1999. Along the way there were dizzying drops, of course — Black Monday in 1987 and the dot-com crash — but if you step back, it’s clear. Stocks truly won.

You can see why investors continue to believe in stocks, whatever the bond gurus have to say about the “death of equities.” While a tactical asset allocation would be a better fit for a market with such wide swings, the will to believe in blue chips is ingrained in a generation of investors.

Now we face some interesting (to put it mildly) challenges. The debt and the deficit; the “fiscal cliff” of expiring tax cuts and automatic budget controls; a presidential election in full swing and suddenly looking competitive; debt problems boiling over in Europe; labor protests and nagging doubts about the world’s now No. 2 economy, China. U.S. Federal Reserve policy remains in completely uncharted territory.

Should I go on?

You would be quite right to be concerned about the likelihood of stocks gaining much more ground from here. We already have come pretty darn close to the all-time closing high for the Dow, set exactly five years ago: 14,164.53 on Oct. 9, 2007.

If it’s bad news you want, there’s plenty to choose from. The International Monetary Fund sees an “alarmingly high” risk of a global slump. Earnings are supposedly coming in lower. Not disastrous, but certainly not the stuff of a real bull market. Choosing a tactical asset allocation over the standard stocks-and-bonds mix starts to sound attractive in these waters.

Nevertheless, as the newsletter tracker Mark Hulbert points out, we are right on top of the “Halloween indicator,” the supposed date upon which all of the “sell in May and go away” folks will come plowing back into stocks, hoping to pick up gains through the next spring. Certainly, we have seen retail investors on the sidelines, waiting for a signal. Could Oct. 31 be it?

Who knows? There are plenty of active tactical asset allocation funds out there, managers who will take your fees and make the effort to get you into the right assets at the right moments.

We have no quibbles with the logic. Just with the idea that money managers have any clue of what’s coming next. Tactical asset allocation is sold as proactive, but in practice it has to be reactive, trying to move your money out of high-risk assets and into safety just in the nick of time.

We read with interest a recent story on MarketWatch about how “cash is king.” The author, an investment advisor, walks through the higher risk (in his view) assets of the moment, then concludes with this:

Finally, we derive some confidence in thinking that cash is the ‘least worst’ option by looking at managers we admire including [GMO’s Jeremy] Grantham. Steve Romick’s FPA Crescent Fund (FPACX ) is holding 32% cash and Jeffrey Gundlach’s DoubleLine Total Return Fund (DBLTX) is holding nearly 20% cash, according to the most recent portfolios published by investment researcher Morningstar Inc.

Romick was a finalist for the Morningstar Manager of the Decade Award in 2010, as was Gundlach. It appears the smart money is getting defensive.

Defensive? Possibly. Yet any tactical asset allocation would designate a certain amount of cash at any point in the business cycle. The glass is half-full and…half-empty.

Tactical asset allocation for the passive investor

What few people grasp about the passive investing style is that it is, ultimately, a form of tactical asset allocation. Rather than trying to ride mostly one asset, a passive allocation holds bonds, commodities, emerging market stocks, foreign developed-country stocks, inflation-proof bonds, real estate, U.S. stocks and, of course, cash.

How much cash? It depends on the flow of dividends. See, a well-built portfolio is always generating cash back to the investor. We believe strongly that it’s better to simply take that cash and not let it reinvest automatically.

The reason is tactical asset allocation: Cash flows in. Soon, the time comes to rebalance. Instead of having to sell (and possibly generate a taxable event) you take the cash and buy enough shares of low-cost ETFs and index funds to come back to balance. It’s passive, yet tactical.

More importantly, you don’t have to be right about what a million strangers might do on Halloween (besides ring your doorbell). Other investors will do whatever they do, while you will stuff your pumpkin with profits and move on.