Retirement on Beach

The Turn of the Tide

Is there change on the horizon? A recent article in Bloomberg Businessweek by Charles Stein details the disenchantment investors are experiencing with stock pickers. Mutual funds that invest in domestic equities have experienced a mass exodus of around $8 billion in redemptions this year alone through June 29th. That type of loss has them closing in on an unprecedented five straight years of withdrawals. This is according to the Investment Company Institute.

But while investors are fleeing the active managers, index funds that invest in U.S. stocks have had a positive influx every year since 2001 according to Morningstar. This growing problem of people evacuating mutual funds appears to be sitting solely in the lap of the active managers. At IFA, we don’t see this as a problem. We view it as an awakening.

Articles like this one are rare indeed. In April 1999, an anonymous writer for Fortune magazine wrote, “"By day we write about "Six Funds to Buy NOW!"... By night, we invest in sensible index funds. Unfortunately, pro-index fund stories don't sell magazines." At IFA, we have active managers as clients. It seems as though they know the right way to invest, but alas, the right way doesn’t make them money.

The trickling of funds from active to index isn’t the only transformation taking place. According to the article, investors are also investing more of their assets in international companies. The problem is most investors don’t know which of these countries is the right one. Is Germany ready to take off? Is Brazil the next emerging market power? Have I missed the boat on China? Turkey? Argentina? If people can’t predict which way a stock will move in the U.S. with any certainty, why would anyone be able to do so with international stocks? Like domestic equities, international stocks have everything baked into the price. The price on international equities is agreed upon by a willing buyer and a willing seller, the same way domestic stocks are agreed upon.

Below are dynamic charts that shows just how random returns across various asset classes and countries actually are.

Borrowing the definition from a recent Vanguard study,

"Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances among different asset or sub-asset classes."

To put it more succinctly, TAA is simply market-timing but with only a set portion of the whole portfolio. For example, an institution may have an SAA of 60% equities and 40% fixed income, but utilization of TAA may allow the equity allocation to vary between 50% and 70% and the fixed income allocation to vary between 30% and 50%. This is equivalent to saying that 80% of the portfolio will have a 60/40 allocation while market-timing (or style-picking) will be performed with the remaining 20%. For institutional investors, TAA occurs at two levels: Investment consultants allocating funds among different asset class managers and investment fund managers allocating funds among different asset classes and sub-asset classes.

It is IFA's position that TAA is a futile exercise because market-timing and style-picking are unproductive at best, and potentially quite destructive at worst. TAA is merely one more attempt by active consultants and managers to deliver the ever-elusive alpha, which as shown in a previous article, has not been reliably achieved through security selection.

So while people continue to stumble in the dark through the active investing landscape towards the light that is passive, IFA will keep talking people home every step of the way.  And fortunately, it appears people are beginning to walk towards the light rather than shielding their eyes from it.

Listen to the orginal IFA Radio's Episode 82: Airs 7/24/11