The constant search for strategic allocations with optimal exposure to markets is a process indistinguishable from market timing and suffers from its biases.
Asset allocators constantly search for the best mix of assets for diversification that offers a desirable Sharpe ratio. New ETPs constantly emerge, and asset allocators investigate how to use them to improve their strategies.
Fundamentally, there is nothing wrong with the process described above. Investing is a constant struggle with the non-stationary nature of financial markets. The problem is that the distinction between strategic and tactical investing has become blurred. Essentially, in a fast-moving world with new product development, strategic allocations are another form of tactical investing.
The distinction was a bit clearer before the advent of ETPs. The 60/40 portfolio in stocks and bonds dominated because it was a solid strategic allocation. Nowadays, fund managers have started adding layers of returns generated by products that may have been developed using backtesting and have a few years of actual exchange life. This process is indistinguishable from a market timer searching for trading strategies. Some of the products added to strategic allocations are, in reality, timing strategies. For example, the newly managed futures ETFs are essentially timing strategies. I consider a managed futures ETF another Commodity Trading Advisor (CTA). There are differences as far as expenses that make those ETFs suitable for inclusion in strategic allocations, but the timing nature of these ETPs is embedded in them.
Say goodbye to traditional strategic allocation. The 60/40 portfolio woes last year accelerated the move towards tactical investing using derivative products. For example, CTAs trade derivatives using timing models. Managed futures ETFs are derivatives of an ensemble of timing models used by the CTAs (the replicated index) trading derivatives. The level of sophistication has increased with multiple levels of derivatives. Creating derivatives on top of derivatives is the modern financial alchemy.
There is hidden leverage and risk of ruin in some strategic allocations due to the derivatives used in some of the products. There are also hidden biases: if backtesting was used to create the ETPs included in those strategic allocations, then they may suffer from data-mining bias. Among other things, this means that when there is a market regime change, these products may not perform as in the backtest and cause losses.
The future of investing is becoming more challenging. Minimizing hidden biases and updating the allocations may become a daunting task.
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Charting and backtesting program: Amibroker. Data provider: Norgate Data
