In Defense of Adaptive Asset Allocation
By Andrew J. Willms, JD., LL.M., CWM
Investors are caught in an ongoing debate about whether asset allocation should remain static or adapt to changing market conditions. Some believe a set-it-and-forget-it approach is the best way to achieve long-term returns, while others argue that adjusting allocations in response to evolving economic and market trends can help manage risk and enhance returns.
In her recent article, Morningstar’s Amy C. Arnott takes issue with adaptive asset allocation, writing “Adjusting asset-class exposure based on changing market conditions sounds good in theory but usually doesn’t work.” Her article follows similar pieces by two of her Morningstar colleagues, Jeff Ptak and John Rekenthaler.1
While these articles highlight challenges some fund managers have had in implementing adaptive (a/k/a dynamic) asset allocation, they fail to distinguish between the diverse ways adaptive asset allocation can be implemented. Treating all adaptive asset allocation approaches as one and the same conflates discretionary, high-fee, tactical strategies with disciplined, low-fee systematic strategies that have delivered strong results and are supported by extensive academic research.
Furthermore, the critiques rely on a passively managed 60/40 portfolio as a benchmark. Comparing dynamic, risk-managed strategies to a static allocation benchmark overlooks adaptive asset allocation’s ability—when implemented cost-effectively and with discipline—to manage risk, navigate market cycles, and capitalize on market factors and trends.
Understanding Adaptive Asset Allocation
Adaptive Asset Allocation (AAA) can be broadly categorized into Systematic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). While both involve adjusting asset-class exposures dynamically, they differ in their implementation and decision-making processes.
SAA relies on predefined, quantitative models that adjust asset class exposures based on objective signals rather than discretionary judgment. These adjustments can occur at predetermined intervals or in response to market conditions, such as changes in momentum, volatility, or macroeconomic indicators. SAA often prioritizes risk management, with practitioners using rigorous research and backtesting to validate strategy effectiveness.
A simple example of a systematic asset allocation strategy might be a model that increases equity exposure when volatility is low and economic growth is stable, using predefined triggers.
In contrast, TAA typically seeks to enhance returns by frequently adjusting asset class exposures in response to recent market and economic data. Additionally, many TAA strategies also rely on discretionary shifts, which can introduce subjectivity and inconsistency. While some tactical strategies incorporate systematic elements, they often involve higher turnover and increased market timing risks. TAA’s increased trading activity can lead to greater tax liabilities and elevated transaction costs, thereby eroding returns.
For example, a TAA strategy might reduce exposure before an anticipated Federal Reserve rate hike or shift into defensive sectors if a market correction is anticipated.
Combining Apples and Oranges
Morningstar’s fund rating system categorizes funds into peer groups in an effort to prevent unfair comparisons across unrelated strategies. However, it has yet to recognize the distinction between TAA and SAA, instead lumping all AAA strategies into its Tactical Allocation category. This conflation results in cost-effective, disciplined SAA strategies being evaluated alongside costly, discretionary TAA strategies that are more susceptible to behavioral biases and poor execution.
In Morningstar’s defense, distinguishing between TAA and SAA is not always easy, as the differences can be subtle. Complicating matters, many firms blend systematic and tactical elements, such as using rules-based tactical adjustments to mitigate risk or employing unscheduled adjustments in an effort to manage whipsaw risk. Nonetheless, equating TAA with SAA diminishes the efficacy of systematic approaches.
The Case for Systematic Asset Allocation
Systematic asset allocation has several advantages, especially for investors who prioritize discipline, risk management, and long-term returns. Here are some key benefits:
1. Discipline and Consistency
· Asset allocation is determined by objective criteria, reducing emotional decision-making.
· Predefined algorithms or models minimize the influence of manager biases.
· Adherence to systematic processes reduces reactive or impulsive trading.
2. Risk Management
· SAA strategies dynamically adjust risk exposure based on market conditions, reducing allocations to risk assets when indicators suggest heightened market stress.
· Rules-based frameworks allow strategies to align with specific investment objectives and time horizons.
3. Transparency and Testing
· Unlike tactical investment management, which may involve unpredictable or opaque decision-making, systematic approaches use transparent rules for asset allocation.
· This transparency assures that investment decisions are made for investors’ benefit rather than driven by external incentives or subjective factors.
· The structured nature of SAA allows for rigorous backtesting and performance analysis, enabling investors to evaluate the strategy’s effectiveness across different market conditions with greater confidence than discretionary approaches.
· Because SAA is rule-based, historical and simulated data can be used to rigorously evaluate its ability to generate alpha and manage risk.
4. Elimination of Individual Stock-Specific Risk
· SAA strategies typically invest in broad-market index ETFs, thereby diversifying away idiosyncratic risk associated with individual stocks (such as earnings surprises, fraud, management missteps).
· By focusing on diversified asset classes and factor-based investing, SAA strategies ensure that portfolio performance is influenced by broader market trends rather than the unpredictable movements of individual stocks.
5. Cost Efficiency
Lower Expense Ratios: Systematically managed funds can have much lower expense ratios than tactically managed funds.
Fewer Transaction Costs: Since systematic strategies generally have lower turnover than tactical strategies, trading costs (such as bid-ask spreads and commissions) are less.
Addressing Morningstar’s Criticisms
Morningstar’s critiques of AAA focus on three primary concerns:
· Long-Term Performance: Morningstar argues that TAA strategies struggle when compared to a static 60/40 portfolio, ignoring numerous long-term academic studies demonstrating that systematic trend-following and factor-based strategies can enhance risk-adjusted returns over full market cycles when implemented with discipline. Additionally, Morningstar’s own research shows that many investors abandon static allocations during downturns, engage in panic selling and miss recoveries. By limiting drawdowns, systematic asset allocation helps investors stay the course, reducing the likelihood of emotionally driven mistakes that erode long-term returns.2
· Risk Management: Morningstar’s assessment of adaptive asset allocation’s ability to manage risk relies solely on standard deviation. However, standard deviation does not distinguish between upside and downside volatility, a crucial distinction when evaluating risk management effectiveness. AAA strategies are designed not just to minimize overall volatility but to reduce large drawdowns—an aspect better captured by metrics such as Maximum Drawdown, Sortino Ratio, and downside deviation. Furthermore, the risk-return profiles of the funds Morningstar classifies as tactical vary widely, with some significantly outperforming others.
· High Costs & Execution Risk: While many discretionary tactical funds suffer from excessive fees and high turnover, systematic strategies are often designed with cost efficiency in mind. For example, the total expense ratios for The Brinsmere Funds3, a family of two systematic asset allocation ETFs, are 0.44% and 0.49%. By comparison, Ms. Arnott found the average expense ratio for funds included in Morningstar’s Tactical Funds category to be 1.40%, over three times as much.
· Fund Closures: While closure rates vary widely, funds with high-fee, discretionary tactical strategies have shown greater susceptibility to failure due to market timing errors and cost inefficiencies. By contrast, well designed systematic strategies emphasize disciplined, risk-managed approaches, making them more sustainable in the long run.
Conclusion
Like all investment strategies, adaptive asset allocation has its challenges. But dismissing the approach based on faulty comparisons to volatile static portfolios or due to the lackluster performance of poorly executed tactical allocation funds overlooks the potential of systematic adaptive strategies.
Academic research and real-world results show that, when implemented with discipline and thoughtful design, systematic asset allocation can be a highly effective investment approach—particularly in uncertain and volatile markets.
Amy C. Arnott, Why Tactical Allocation Funds Failed—Again, Morningstar, January 2024, Link; Jeff Ptak, They Came, They Saw, They Incinerated Half Their Funds’ Potential Returns, Morningstar, December 2023, Link; John Rekenthaler, Have Tactical Asset Allocation Funds Earned Their Keep?, Morningstar, November 2023, Link.
See: Morningstar. Mind the Gap: Why Investor Returns Often Underperform Fund Returns. Morningstar, 2024.
Andrew J. Willms is the President and CEO of The Milwaukee Company, a registered investment advisory firm located in a suburb of Milwaukee. The Milwaukee Company is the investment advisor to The Brinsmere Funds.