Tactical asset allocation is the practice of fine-tuning an investment portfolio to meet changing market conditions. This article discusses how Haisman Wealth Management, Inc. uses ETFs when implementing a tactical asset allocation strategy for your portfolio.
Exchange-traded funds (ETFs) may be ideal tools for helping portfolio managers implement a tactical asset allocation strategy. A general understanding of tactical asset allocation can help crystallize this strategic use of ETFs.
The process of creating an allocation started with an assessment of your age, goals, and risk tolerance. Because these factors are fixed, many assume that the resulting allocation plan must be static. However, every asset class has its own unique market cycles and economic influences. We can often identify these individual patterns and use that insight to guide us in the investment processes — shifting value to an investment that might outperform the average from an asset type showing potential to lag behind. ETFs can provide a high degree of precision in targeting the exact proportions needed for this effective tactical execution.
It is important to emphasize here that tactical asset allocation is not the same thing as market timing. Tactical allocation adjustments are a form of fine-tuning for an established long-term master plan, often done in response to broader market trends. Such measured alterations to the core blueprint may be left in place for weeks, months or even years as investment conditions warrant. Market timing, on the other hand, is more like betting — its success depends on profitably gauging the size and scope of random market spikes while avoiding the equally prevalent random market troughs.
Exploitable Asset Class Cycles
Tactical asset allocation is active asset reallocation — that is, changing your investment mix in response to actual trend and price changes as markets rise and fall and the economy strengthens and weakens. For example, stocks and bonds each have their own bull-market and bear-market cycles. As a consequence, there will be times when stocks are overvalued relative to bonds, and vice-versa. Furthermore, there will be times within each asset class’s market cycle when some identifiable subset of those assets moves out of line from the overall average. The asset of opportunity may be a particular class of bonds, or a certain category of stocks. We may use niche-focused ETFs to increase your investment exposure to just those asset categories that might be needed to “stack” the investment deck as much as possible in your favor.
Market Measures That Can Be Exploited by ETFs
Trend and Relative Strength
Here at HWM our analysis and especially that of our outside portfolio advisors, can be boiled down to two main measures: trend and relative strength. Trend is an absolute measure of strength, as it tells us the direction of movement. Are prices rising (positive trend), or falling (negative trend)? On the other hand, relative strength allows us to measure the potential magnitude of this movement; so if price is increasing to what extent can we expect it to increase relative to something else? ETFs are ideal for implementing this strategy because of their flexibility and availability in all asset classes.
Deciphering the Truth
In the context of investing, how do we as managers of your portfolio, determine which analysts, economists, etc. can be believed and which may be obscuring the truth relative to where best to invest? The reality is that it can be nearly impossible to tell. However, one of the major benefits of our systematic relative strength models is that the input to the relative strength model is a single, objective data point: price. That price is simply a reflection of the supply and demand relationship for a given security. Furthermore, price reflects the collective judgment of all market participants. No longer is an individual investor in the position of trying to determine truth from untruth. Rather, the focus becomes capitalizing on the trends of the collective judgment of all market participants.
We pay close attention to relative performance. When an asset strengthens, we are interested in owning it. If it is performing poorly, not so much. Relative strength allows supply and demand, as reflected in market pricing, to make the decision about what is valuable or not at any given time. It allows the portfolio to change as conditions change, without requiring useless forecasting.
Other Considerations for Tactical Allocation
For as many different ways that investment can be categorized, there are opportunities for fine-tuning an allocation to take advantage of divergences in performance cycles. Large-cap stocks and small-cap stocks each have unique market cycles. So do each individual country and geographic region of the world. Keep in mind that the statistics for measuring these cycles might be imprecise, adding uncertainty to any active reallocation program.
We have found that a successful implementation of a tactical allocation plan requires more attention to maintenance than a static portfolio. Turnover — selling one asset while simultaneously buying another — could be costly. Traditional commissions and fees can be considerable, and a reallocation transaction can create a capital gains tax liability. To minimize these negatives we focus on ETFs which we can buy inexpensively and are quite tax efficient. Because each ETF is clearly focused on one asset class or style, it can be well suited for executing changes in allocation policy.
Points to Remember
1. Tactical asset allocation is the practice of adjusting portfolio allocation to meet changing market conditions or exploit market cycles. It is not an attempt to time the market by betting on short-term volatility.
2. Exchange-traded funds (ETFs) allow us to realign allocation by adding precisely the asset class, style, and amount needed to achieve any desired effect.
3. Tactical asset allocation using ETFs allows us to easily change the mix between asset classes in a number of portfolios.
4. Asset classes can be comprised of investments in US Equities, International Equities, Commodities, Fixed Income, Currencies and also Cash.
Primary individual investments are based on supply and demand which we, and our outside consultants, are able to track with some accuracy.
1Source: Standard & Poor’s. The S&P 500 is an unmanaged index of stocks considered to be representative of the large-capitalization U.S. stock market. Investors cannot invest directly in any index. Past performance does not guarantee future results.
2Source: Standard & Poor’s. The S&P 500 is an unmanaged index considered representative of large-capitalization U.S. stocks. For the period January 1, 1997, to December 31, 2011. Investors cannot invest directly in any index. Past performance does not guarantee future results.