5 Charts Explain Why Alt & Tactical ETFs Work

November 09, 2017

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 reach the end of 2017, U.S. and international equities continue to climb higher with record-low volatility levels. Even perceived safe-haven assets, such as gold and long-term U.S. Treasuries, have joined the rally this year.

As a result, a diversified portfolio—such as iShares Core Moderate Allocation (AOM)—is enjoying historically high risk-adjusted returns. Plotted below is the rolling one-year Sharpe ratio for AOM and its historical quartiles. 


Alternative & Tactical ETF Allocations

For a larger view, please click on the image above.


Diversification Vs. Risk Mgmt

In such an environment, it’s not surprising to see a growing sense of apathy toward risk management. If traditional diversification is working, why bother incorporating nontraditional exposures or strategies?

Yet the chart of rolling Sharpe ratios also shows that market conditions can change quickly. Traditional stock/bond mixes may “feel good” today, but history shows that we’re likely experiencing a positive outlier, not a new normal. Volatility will return.

We know that elevated volatility—and the material drawdowns that can come with it—can be devastating for all investors; particularly so for those near, or in, retirement. Historically, core bonds have served the role of “safe ballast” within a portfolio to help mitigate this risk.

Today however, the decline of interest rates to near-zero real rates makes core bonds a far less compelling investment.

As a reminder, the current yield of approximately 2.5% serves as a good estimate of core U.S. fixed income’s expected total return before inflation. Add in a reasonable inflation estimate of around 2%, and the real return of bonds for the next decade is estimated at 0.6%.


Alternative & Tactical ETF Allocations

For a larger view, please click on the image above.


Data Source: Robert Shiller’s data library. Calculations by Newfound Research. Expected bond return is equal to nominal yield less an estimate of long-term expected inflation.



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