[Beating investment benchmarks have been the bane of active managers’ existence. While many do, the SPIVA reports (S&P) document how a large cross-section of mutual funds underperform their index with the most recent 2021 year-end report stating 76.67% of U.S. mutual funds underperformed the S&P500. Many investment strategies have been developed to try to beat their benchmarks ranging from mirroring their index with 5-10% tactical tweaks in deemed under- and over-performing components of their index, to concentrated strategies that cherry-pick the standout management teams or business models, to adding specific proprietary macroeconomic or other tactical overlays that dynamically alters the portfolio holdings in their chosen benchmark’s universe of stocks. Many aspects of the ongoing evolution and innovation in asset management lies in these continuing efforts.
The Institute was recently introduced to an asset manager with a singular conviction to outperformance by employing a “clearinghouse” of investment strategies that were determined by reverse engineering their funds’ benchmarks. The key to this investment philosophy is flexibility by creating diversification by investment strategy, subadvisor managers, and a multiple time frame perspective selected based on the needs of each fund relative to its index or benchmark.
To explore this further, the Institute reached out to Drew Horter, president and CEO of Tactical Fund Advisors — a growing Cincinnati-based fund group providing risk-managed, multi-strategy mutual funds designed to dynamically adapt to changing market environments. In our discussion we wanted to better understand their investment strategy and the process behind reverse engineering an index or other benchmarks.]
Bill Hortz: How do you design an investment strategy to compete directly with its index or Morningstar category?
Drew Horter: In developing the fund allocations, we start with a core strategy designed to compete directly with the benchmark or category. For this portion of the portfolio, we first determine the asset class breakdown of the category. For example, we know the Morningstar Moderate Target Risk Category allocates 59% to equities, 40% to fixed income and 1% to cash. Next, we look at the allocations to cap sizes and styles within each asset class for equities, as well as the allocations to core, short-, intermediate and long-term bonds, foreign bonds, REITs, TIPs, etc.
Armed with the allocations to the asset classes, cap size, style, and class sector data, we then build out our strategy holdings, which are tilted slightly to over/underweight the category allocations based on our macro view. In short, we strive to outperform the category making a concerted effort not to “reach” too far for alpha with this part of the portfolio. Our view is this approach acts as an excellent anchor to the portfolio.
From there, we employ multiple strategies which are selected for their ability to deliver alpha, a targeted volatility range, appropriate upside and downside capture, as well as the correlation to the market, and other strategies within the fund. We then monitor performance on a daily basis as well as portfolio statistics for each strategy monthly.
Hortz: Can you break down further with specifics how you reverse engineered the benchmarks around some of your funds?
Horter: We currently manage four multi-manager TFA Tactical mutual funds. So let me focus on a few:
TFA Tactical Income Fund (TFAZX) — We began with an exhaustive examination of Morningstar’s top Non-Traditional Bond Funds benchmark category. We noted that even the best funds frequently move on and off the leaderboard. We attribute this phenomenon largely to singular strategies tied to specific investing approaches moving in and out of favor with changing market conditions. In response, we have designed an adaptive blending process utilizing multiple managers and strategies. The overall goal is to produce more consistent outcomes over a market cycle. Our unique quantitatively driven investment strategies build on a core of diversified bond ETFs, layering on blends of multiple econometric, trend-following, and mean-reversion approaches.
Econometric approaches weigh in on national economic health, matching the most historically favorable holdings to the current economic cycle. Trend following strategies work on the principle that recent trends will continue into the near future, while mean reversion strategies utilize the concept of prices being overbought or oversold. Many of the funds sub-strategies may also use levered or inverse ETFs to potentially enhance performance in differing market environments, including those that may otherwise be fundamentally unfavorable to fixed income.
All traded approaches may invest in the full spectrum of credit and duration ETFs, making the overall fund a go-anywhere tactical income approach. Allocations among the sub-strategies may further be dynamically adjusted according to their cross-correlation, relative trend and volatility characteristics using a proprietary mechanism, permitting the concentration of strategies to further adapt to evolving markets.
Finally, within the boundaries provided by Morningstar and the Morningstar Non-Traditional Bond Category, a maximum 15% allocation to hedged equity exposures is provided with the goal of further enhancing total fund returns while still targeting reduced downside risk and non-correlation appropriate to the fund category. This is designed to seek steady fixed income-focused returns featuring capital protective overlays and reduced interest rate correlation without the inherent risks of a singular manager approach.
TFA AlphaGen Growth Fund (TFAGX) — The portfolio development process for TFA AlphaGen Growth Fund began with an extensive analysis of Morningstar’s top Tactical Allocation Funds category. Once again, we found that even the top-rated funds frequently moved on and off the Morningstar leaderboard due to the fact that most funds employ a singular investing strategy which can fall in and out of favor as market conditions change. Our goals for the AlphaGen Growth Fund were to (1) create a more consistent return stream over a full market cycle, (2) afford the fund the ability to dynamically adapt to changing market regimes, (3) employ a globally diversified approach, and (3) build in risk mitigation techniques designed to preserve capital in nasty bear market environments.