Last Updated Oct 15, 2010 3:40 PM EDT

With the paltry returns provided by the stock market over the past decade, many mutual fund investors are reassessing their approach to investing. The wisdom of buy-and-hold, which was so simple and profitable to adopt during the two-decade-long bull market in stocks and bonds, is being questioned. In many cases, investors are considering a more hands-on approach.

A recent Morningstar interview with Jason Zweig focused on one of the alternatives that’s being adopted — tactical asset allocation.

Unfortunately, as Jason noted, investors embracing this approach as a way to improve the performance of their portfolios are likely to be disappointed.

Tactical asset allocation is the impressive sounding name of an approach in which the investor attempts to navigate their way through choppy financial markets. Rather than just blithely accepting whatever returns the stock and bond markets deliver, tactical asset allocators go on the offensive. They sell stocks when they’re overvalued; they sidestep bubbles in one asset class or another; and their free rein allows them to seek value in overlooked securities or asset classes.

Lipper classifies funds that adopt a go anywhere strategy as flexible portfolio funds. Whereas most fund managers are relatively constrained by their funds’ mandates, managers of flexible portfolio funds are much more free to roam, able to cycle from one asset class to another as they see fit, and in many cases, able to short stocks that they feel are overvalued.

The names alone of many of the funds in this category are enough to inspire confidence in their managers’ ability to not just survive, but thrive in uncertain times. Terms like alternative strategies, market opportunity, multi-hedge, select allocation, and multi-disciplinary are rife.

With all of this freedom, all of their training, and a wealth of research at their fingertips, it might be instructive to take a look at how well the average manager in this category fared at identifying the best and worst times to be in the stock market.

There’s no doubt that over the past decade the stock market has provided market timers with an embarrassment of riches in the form of numerous opportunities to avoid or take advantage of big moves up or down.

So how did flexible portfolio managers do? Since the end of 1999, the average flexible portfolio fund held a stock allocation of 63 percent, which will serve as our benchmark. In March 2000 — just weeks from the market’s then-all-time-high, the average fund in this category was actually overweight stocks, with a 66 percent allocation — 6 percent higher than their average.

At the market’s subsequent low in September 2002, that allocation had fallen to 61 percent — 3 percent lower than their long-term average. The group’s stock allocation drifted up over the next few years, and reached a slightly-overweight 64 percent in September 2007 — just weeks from the S&P 500’s all time high. Carnage quickly followed, of course, and when the bear market bottomed out in March 2009, the average flexible portfolio fund was significantly underweight stocks, with an average allocation of just 53 percent.

Notice a pattern here? Rather than underweighting stocks at the market’s peaks and overweighting them at the bottoms, the managers of these funds were doing precisely the opposite — loading up on stocks when everyone was optimistic, and underweighting them in times of despair.

It seems that for all of the hedging and opportunity identifying/seizing that these funds are supposed to offer, their managers have ended up falling victim to the same emotional traps that ensnare so many investors. This is hardly a new phenomenon. In the early part of the twentieth century, John Maynard Keynes noted that it’s far more acceptable for money managers to fail conventionally — i.e. follow their emotions and their fellow investors into and out of the stock market — than to succeed unconventionally.

Largely as a result of that poor timing, the average flexible portfolio fund — including those which have been merged out of existence — has earned an annual return of just under 2 percent since 1999, trailing the 2.8 percent return provided by buying and holding a 60/40 portfolio divided between the total domestic stock and bond markets. Compounded over the entire period, the average flexible portfolio fund earned a cumulative return of 24 percent, versus 35 percent for the buy-and-hold approach.

There’s no denying the appeal of an approach like tactical asset allocation, particularly when the financial markets are offering such meager rewards in return for the stress they produce. But in the end, successful investing is all about minimizing mistakes — both your own and those made by your mutual fund managers. Which is why the notion of increasing your odds for success by increasing the number of decisions you and/or your managers are making by adopting a tactical asset allocation approach is, in the end, counterintuitive.

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