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No Liquidity for You (or Your Clients): Tactical Allocation Funds

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More and more advisors are opting to use tactical allocation funds as part of their offering to clietns. These funds change their risk profile in response to changing market conditions to avoid large losses. Very few of them actually buy protection as options are relatively expensive.  Instead they use algorithms that respond to market volatility and essentially act as a stop loss mechanism, going to cash.

It is easy to understand why some bright advisors decided to try this approach. Markets don’t go up forever and the current zero cost credit binge will have to end sometime in the future. At the same time investment-grade bonds barely offer enough yield to catch up with inflation. So advisors use these tactical allocation funds to get equity-like returns, but keep the downside limited.

Every individual advisor is fully justified in this move, but let’s consider what this means in aggregate. If there are enough funds that take a similar action when market breaches some support levels the avalanche effect could easily ensue. These funds take advantage of programmable trading in very liquid vehicles to limit downside.

Black Monday and ‘Portfolio Insurance’

If you think that algorithmic trading in a highly liquid market to limit downside is a recent invention, think again. In fact, programmable trading strategies were the main culprits behind the dramatic market crash on Oct. 19, 1987, which saw U.S. equity markets drop over 22%. A variety of strategies such as ‘portfolio insurance’ were used for protection against big losses.

Portfolio insurance is a strategy that sold stock futures into a falling market to control risk. On Oct. 12, 1987 an article published in The Wall Street Journal expressed a fear that using portfolio insurance “could snowball into a stunning rout for stocks.” The  price-to-earnings ratio today is over 20, while the P-E was 19 on the eve of Black Monday. Leverage in the financial system is much higher today, resulting in more vulnerability, though the Federal Reserve has massive stimulus programs and stands ready to step in to support liquidity.

Implications for Advisors

We are certainly not saying that any market crash is imminent.  However, one important lesson from history is that there is no such thing as liquidity for everyone, as John Maynard Keynes observed long ago. While every individual decision to go into a tactical fund makes perfect sense, in aggregate not all of those funds will be quick enough to execute their strategies. 

Advisors must have a structured risk management process that does not rely exclusively on tactical allocation funds. Worst-case scenarios have to be explicitly discussed with clients to avoid selling at the bottom of the market.