Tactical Asset Allocation seeks to maximise returns while minimising losses. Most strategies are designed to catch a trend and keep it for as long as it lasts, using absolute or relative momentum (or a combination of both, called dual momentum). Once momentum is negative, those strategies shift to a defensive risk allocation by dumping the portfolio into bonds or cash. While this indeed preserves from more significant losses, blindly allocating to a defensive risk posture, regardless of how that asset is currently performing, is an essential flaw in a strategy.
Up until 2022, back-testing those strategies didn’t reveal this flaw because of the 40+ years epic once-in-a-lifetime run in US Treasuries. The inverse correlation to stocks helped some strategies to make gains even in adverse market conditions. When interest rates started rising, some strategies exposed their “dumping to bonds” flaw when bonds failed to offset risk asset losses.
In 2022, Bonds, usually a reliable diversifier during market downturns, imploded simultaneously with risk assets. The S&P-500 lost -23.9% in the first 9 months, while intermediate-term US Treasuries lost -15.6%. This was significantly worse than the 2000-02 drawdown (-2.8%) and the 2007-08 drawdown (-7.1%). Such a drawdown is uncommon and has not been seen since 1907-1931.
We can only assume that the affected Tactical Asset Allocation strategies either didn’t foresee the possibility of risk assets and bonds imploding simultaneously or considered the risk too remote to account for. Given the difficulty of estimating asset class data so far back into the past, some developers perhaps hadn’t considered it in their strategy design or saw it as the distant past with no relevance to today’s market.
One can conclude that bonds are not a reliable diversifier during periods of market weakness. However, this should not imply that bonds should be an integral part of a portfolio. What matters is the design of the strategy and how it protects against losses in risk assets. Strategies blindly dumping the portfolio into bonds tend to fare poorly, especially with rising interest rates ahead. Strategies do well that treat defensive assets just like offensive assets. For example, they require defensive assets to exhibit positive momentum.
Our core strategies Canary Asset Allocation and Dynamic Asset Allocation precisely do that. They hold the 4(3) assets out of a universe of 8(6), showing the highest relative momentum. Every asset class is treated equally. Therefore, there is no survivorship bias or risk of hindsight bias in our core strategies.
Our rotation strategies use bonds as a risk-off asset. Those “risky, but highly rewarding” add-on strategies have impressive long-term returns, but their peaks and valleys have been higher and lower than all our other strategies. By absolute measure, they didn’t do as well in 2022 as our core strategies. We suggest allocating not more than 10-20% of a client’s overall portfolio to those strategies and because of that, they didn’t impacted results in a meaningful way.
As we are moving forward from 2022, we will look into ways to dynamically apply the defensive asset based on the same measures as our risk assets: momentum. When the defensive asset is chosen, we follow the same rules as for the risk assets. If the defensive asset fails the rules, the strategy will instead allocate to cash.
