Go Tactical Within Your Portfolio

November 09, 2015

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 LLC.

The emotional aspect of investing often centers on risk. Whether it is the risk of losing out on the next best thing, of not saving enough for retirement or suffering a large drawdown, risk for many investors is emotional.

As a result, many investors blend risky and safe assets in their investment portfolio. A strategic blend of these asset classes is a common starting point, with equities used as both a growth engine and inflation fighter, while bonds often serve as a safety dampener to market volatility and capital loss.

As we know, investors hate losses more than they enjoy gains. But simple-yet-robust tactical strategies can remove some of the emotion of making asset allocation decisions and provide investors with a better portfolio experience.

Consider our simple portfolio example of stocks and bonds. We will now construct a tactical portfolio that invests in stocks when momentum is positive and in bonds when momentum is negative. Momentum will be measured using a price-minus-moving-average cross-over system between the S&P 500 Index (total return) and its 200-day moving average.

Starting with a 55 percent stock/45 percent bond portfolio, we will create a new portfolio that is 55 percent stock/25 percent bond/20 percent tactical. In positive momentum environments (price > 200-day MA), the portfolio will shift to a 75 percent stock/25 percent bond allocation. In a negative momentum environment (price < 200-day MA), the portfolio will revert to its 55 percent stock/45 percent bond allocation.

This process is designed to help the portfolio achieve risk ignition by increasing our risk profile when stocks are climbing and decreasing our risk profile when stocks are falling. More importantly, this process is repeatable and unemotional.

In our simple example, we can see that the portfolio with the tactical sleeve exhibits returns in excess of the 75 percent stocks/25 percent bonds portfolio while exhibiting a drawdown in line with the 55 percent stocks/45 percent bonds portfolio.

55/45 Portfolio 75/25 Portfolio 55/25/20 Portfolio
Annual Return 7.85% 8.39% 8.73%
Annual Volatility 9.36% 11.77% 10.52%
Max Drawdown 27.91% 41.35% 29.31%

Tactical Strategies As Asset Allocation Tools

The above example is just one allocation adjustment from a strategic portfolio to incorporate a tactical strategy. Allocating away from strategic allocations in different degrees provides tremendous flexibility to an investment portfolio.

Below we summarize a few broad examples on how using a tactical equity portfolio with the ability to go fully defensive can be used in different ways:

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