Every large-scale project, from a military conquest to building a bridge, requires both strategy and tactics. Strategy refers to the large-scale, long-term decisions: How will the project be funded? What materials should be used? What is the scale and time frame? Tactics are the concrete choices that must be made to execute the strategy, from who will manage the project funds, where materials should be purchased and how to adjust deadlines based on issues that arise while the project is ongoing.

Both words were originally terms of statecraft and war. Now, they have value when describing portfolio construction. The American Heritage Dictionary defines the two terms as, "Strategy: A plan of action...intended to accomplish a specific goal;" and "Tactic: An expedient for achieving a goal; a maneuver."

Strategy clearly indicates a long-term holistic plan. Tactics are more immediate and short-term. Interestingly, however, one meaning of "tactical" is "characterized by adroitness, ingenuity or skill." Not only are tactics about execution, they're about executing successfully due to skillful assessment of and adjustment to the situation at hand.

Although strategy and tactics should work together symbiotically, in the world of portfolio management that often isn't the case. Among portfolio managers, strategic and tactical behavior represent different approaches. A strategic portfolio will likely have a predetermined plan that can be clearly explained, whereas a tactical portfolio will be more difficult to explain in advance because it reacts to changing conditions.

Since 2008, the debate between strategic and tactical portfolio managers has sharpened. Which approach has been more successful? To answer this question, we'll analyze the long-term performance of mutual funds, using the funds' turnover ratios as a measure of their tendency to be strategic or tactical.

WHY TURNOVER RATIO?

Morningstar, the source of the data for this study, defines turnover ratio as "a measure of a fund's trading activity, which is computed by taking the lesser of purchases or sales (excluding all securities with maturities of less than one year) and dividing by average monthly net assets. In practical terms, the resulting percentage loosely represents the percentage of the portfolio's holdings that have changed over the past year."

In this study, funds with a higher turnover ratio will be categorized as having a tactical management approach, while funds with a lower turnover ratio will be viewed as having a strategic management approach. The study looks at three categories of mutual funds: large-cap blend U.S. equity, large-cap blend non-U.S. equity and U.S. intermediate bond funds. We chose these categories because they are core asset classes that are found in virtually every investor's portfolio and because they're big enough that, after employing the screening filters described below, sufficient funds remained for analysis.

Funds included in this analysis must have 10 years of performance as of Dec. 31, 2009, and have a high equity style consistency rating. In addition, index funds were excluded from this study, and only distinct funds were considered (that is, only one share class was included among funds with multiple share classes, usually the share class with the largest asset base).

Large-cap blend U.S. equity funds. Let's start with U.S. equity funds in the large-cap blend category. Equity funds with characteristics of both growth and value are classified as "blend" funds. For these, 131 funds met the selection criteria and were divided into quartiles according to average turnover ratio over the past 10 years (2000-2009). The average turnover ratio for each fund was determined by calculating the average from the last 10 years' turnover ratios.

As shown in "Equities at Home," the first quartile had an average 10-year turnover ratio of 11.1% (this is the low turnover quartile). The fourth quartile had a 10-year average turnover ratio of 111.6%. Now we have our contrasting groups: the first quartile representing a more strategic approach to portfolio management, and the fourth quartile representing a more tactical approach. A strategic approach (low turnover first quartile) outperformed a tactical approach (high turnover fourth quartile) over the past three, five and 10 years.

Turnover ratio isn't a perfect measure of "strategic" and "tactical" management behaviors, of course. There is no perfect measure, but turnover ratio is likely the best single discriminating variable that separates these two portfolio management styles.

Large-cap blend non-U.S. equity funds. Next, let's look at non-U.S. stock funds (large-cap blend category). A total of 55 funds met all the criteria. As shown in "Equities Abroad," the difference in turnover ratio between the first and fourth quartile was again significant. The first quartile had an average 10-year turnover ratio of 29.8%, while the fourth quartile had a 10-year average turnover ratio of 130.5%. Turnover ratios in general were higher with non-U.S. funds than with domestic funds. Again, the low turnover (strategic) first quartile markedly outperformed the high turnover (tactical) fourth quartile.