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Adaptive Asset Allocation Comes of Age

As 401(k) participants feed on a steady diet of high volatility since the crash of 2008, mounting evidence suggests that a market-driven investment approach—what early adopters call tactical, active, or adaptive asset allocation—should no longer be viewed as something new or risky. Rather, adaptive account portfolio management is now an option that plan sponsors should seriously consider introducing to their plan participants.

Rather than ignore market fluctuations as buy and hold, or modern portfolio theory’s pie chart rebalancing formula would dictate, an adaptive approach directs the investor to regularly reallocate their funds according to the market’s actual movements, thus leading to greater financial success in the long term. To be sure, there was a time when such strategies were new to many, but when the Wall Street Journal chooses this style for critique, financial bloggers and researchers (e.g., Adams, Philbrick and Gordillo), and organizations such as the CFA Institute make a market-driven approach a standard option, and major providers like TIAA begin offering adaptive asset allocation style models to their clients, it might be time to finally sit up and take notice.

Investment strategies which adapt to market trends, generally called momentum theories, have been offered since the 1980s, but by 2009, when Nobel Prize winning economist William Sharpe published Adaptive Asset Allocation Policies, the strengths of this approach had finally become clear.

Two new studies involving an adaptive approach are especially telling. According to a recent report by Invesco’s US Market and Research Group, Think Active Can't Outperform? Think Again, adaptive asset allocation is in fact leading the field in performance. In the first of their white papers comparing active versus passive strategies, they found 61% of “high active share fund assets beat their benchmarks,” while active management “significantly outperformed” traditional cap-weighted portfolios in downside capture, showing them “better able to weather negative return environments.” Most important, “even after adjusting for risk, actively managed portfolios performed better in aggregate.”

As part of a series dealing with major US mutual fund families, a Seeking Alpha study of a portfolio of three TIAA mutual funds (one income fund and two equity funds), managed three different ways—a buy and hold strategy, a typical target allocation strategy, and adaptive reallocation strategy [1], —concluded that the adaptive approach “delivered stable returns, with low volatility and low drawdown.” Measured even across the major downturn of 2011—a challenging period for many active investors—between 2010 and 2015, the adaptively managed portfolio still outperformed the other two. Even more interesting than its performance was the adaptive asset allocation strategy’s inclusion in this review as a standard third option in their comparison. Similar studies comparing performance of these now three accepted investment strategies are planned for other major fund groups.

Most important to realize now is that adaptive approaches are part of the new normal for a broad range of savers in retirement investing, and well worth the consideration of any 401(k) plan sponsor for inclusion in their current or planned offering of plan participant education and tools.

Kevin L. Coppola, President, Compass Investors, LLC

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