This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Andrew Gogerty, vice president of investment strategies at Boston-based Newfound Research.
As we sit in 2017—nine years after the financial-crisis bull market began—markets are marked by stretched valuations in both equity and fixed income. Perhaps worse, in a traditionally strategically allocated portfolio, combined valuations are near all-time highs.
As such, we believe that alternative means of robust risk management should be a valued part of a portfolio.
This is where tactical asset allocation can come into play. The ability for these types of strategies to tactically tilt away from perceived areas of high risk gives them the ability to act as an active risk management technique. However, correctly incorporating tactical approaches requires acknowledging and addressing the pros and cons of the philosophy.
The pros are certainly enticing: empirically strong downside risk management for sustained drawdown periods (e.g., 2001, 2002, 2008); the ability to reduce focus on correlation-based risk management; and long history of academia and practical evidence.
The cons, however, should not go overlooked. With tactical strategies, there is a risk of increased investor misbehavior due to tracking error, and increased exposure concentrations can exacerbate short-term market risks.
In balancing these pros and cons, we advocate using three simple commandments to successfully incorporate a tactical strategy into a portfolio.
‘Sin A Little’
We’ll be the first to admit that tactical asset allocation is not the Holy Grail (in fact, we’d argue there is no Holy Grail approach, but that’s a point for another article). We believe that thoughtful strategic asset allocation is still one of the best, most cost-effective ways to build a starting core portfolio.
In fact, we believe tactical approaches are best used as a satellite sleeve designed to complement a core portfolio. The reason we prefer this approach is due to the increased tracking error that tactical strategies often have to traditional asset classes.
We’d point out that this tracking error is a feature, and not a bug, but it can still cause considerable anxiety for investors. If this tracking error causes too much anxiety, investors will abandon the approach; often at exactly the wrong time. Avoiding this behavioral bias is important in designing a sustainable investment portfolio.
Therefore, while we believe the long-term evidence for the efficacy of tactical asset allocation is abundant, we have to recognize that the optimal portfolio is first and foremost the one that investors can stick with.
Positioning a tactical sleeve between the core stock and bond allocation provides a two-way benefit to a portfolio. Consider a standard moderate portfolio: