Why 2017 May Call For Tactical Asset Management

Tactical management is not the same as active; here’s why.

There are reasons to be optimistic about 2017, and reasons to be extremely cautious, says David Haviland, managing partner and portfolio manager of Beaumont Capital Management, based in Needham, Massachusetts. Here, he shares his outlook, his concerns, and why he thinks the New Year might be a good time to consider going tactical.

ETF.com: What's in store for investors in 2017?

David Haviland: I’m cautiously optimistic. What we’ve been experiencing since the election has been a classic buy-the-rumor rally. And the rumor is all of the promises that President-elect Trump had made during the campaign. If everything goes well, then I think everything's fairly valued.

We’re talking about tax cuts, both at the corporate level and the individual level; the infrastructure stimulus he's proposed, which is $1 trillion over the next 10 years; and the promise to renegotiate some of the trade agreements to make sure they’re fair.

If all of these things come to fruition, the hope is that we're going to get some reflation into the world economy, and that the velocity of money should increase a little bit. All of that holds for a very bright future for the U.S.

However, you've still got to make sure we don't go too far. Specifically, I understand what President-elect Trump is trying to do with China, but if he takes it too far too fast, we're messing with the world's second-largest economy. We don't want to jeopardize that relationship, let alone with the EU or elsewhere in Japan.

With the infrastructure buildout, this is very, very enticing to me, because of the need for infrastructure throughout this country. If this gets muted to the point of not being big enough of a spend to make an impact, there could be a lot of disappointment in the investment world.

ETF.com: Is there a risk of spending too much in infrastructure?

Haviland: A trillion dollars over 10 years is basically $100 billion a year. That is a rounding error to our federal budget. So, I would argue, no. Also, you're going to be employing a lot of people.

Those people will then pay federal and state income taxes. So a lot of this money will not be for naught and just wasted away if we're actually building something and employing people in doing it. The governments will get some of that money back. And most importantly, now you've got more Americans being put at work and they get to spend money.

The best way to get rid of high debt as a percent of GDP is to grow the economy. So there are a lot of benefits here. If we just fritter the money away, I suppose, yes, that could become an issue.

ETF.com: What are your biggest concerns looking ahead? You mentioned China, for instance.

Haviland: Rising interest rates. And I'm not talking about a little bit. But if we went up another 2-4% from here, it's going to cause a lot of problems.

The first problem will be with the federal deficit itself, because right now the federal government is enjoying a very-low-interest-rate environment. The average duration of the debt of the U.S. government is only about 5.8 years.

So if inflation picks up and we have to refinance these bonds at higher and higher coupons, it's going to cause quite a bit of duress, because where does that money come from? Or do we just start borrowing more and more and more?

The Federal Reserve and the federal government have got to be careful. We want some reflation into the economy, but we don't want runaway inflation or stagflation. So to me, the No. 1 concern is interest rates.

ETF.com: What do you recommend in terms of asset allocation for 2017? How should an investor position their portfolio?
Haviland: In equity markets, we don't try to predict or recommend far out into the future. We've got three rules-based systems that we use to manage money. And they're all very different, but they share the same characteristics; namely, take what the market is giving you when times are good; and then, preserve capital and seek to get out of the way when markets enter periods of failure.

For instance, our sector rotation system right now is invested in materials, energy, industrials and tech sectors, as well as financials. We'll have been fully invested since early this year. And we've enjoyed this rally. But no one knows what the future's going to bring.

ETF.com: In fixed income, how do you avoid significant losses going forward?
Haviland: I believe in the philosophy of making a lot of little moves in a portfolio. I don't think it’s too late to make fixed-income portfolios better able to handle the coming turbulence, whether it's driven by the Federal Reserve increasing rates, or any other cause.

First, quality is going to outperform both junk bonds and emerging market bonds in the coming months. Yes, high yield has done well for so long, but it's long in the tooth. The yield on high-yield bonds is down around the 4/4.5% range. If it gets north of 7 or 8%, then we would say that's a good time to get back in.

High yield tends to be very cyclical, and it most often pays to invest when the yields are high, and to sell when the yields are low. And that's exactly where they are right now.

There's nothing wrong with going with active bond managers, particularly in a rising interest rate environment, or in a choppy interest rate environment. Make sure you're seeking out experts that can help guide you through the rising rate environment.

Finally, bring your duration in. If you're investing in that 20- to 30-year bond, just look at your risk and reward. What could you possibly get if rates were to go down 1% versus what will happen if rates go up 1%?

And if you're a retiree, why play with fire? The reward you're going to get just doesn't cover the amount of risk you're taking. We suggest, for now, short duration, increase quality, let rates rise and come to a new equilibrium point and then look to re-extend your credit and duration risks.

ETF.com: How do you pick a tactical manager? Is it important to differentiate here a tactical manager from an active manager?

Haviland: It is. An active manager still follows an index. And they’re paid to beat that index; meaning, literally, their bonus and their compensation is going to be tied to how they perform relative to that index.

So active managers, by and large, are seeking relative performance to an index. But the average investor is worried about absolute performance. And what the average investor expects an active manager to do is to grow during the good times, but protect their capital when times are bad. That's where there's a major disconnect.

Look at all the growth mutual funds in 2008. They went over the cliff just like the index funds did.

A tactical manager seeks to give the vast majority of the upside when times are good, but also to protect the capital when times get bad. There's a big difference.

ETF.com: Is this your call for 2017? Brace for downside if the market decides to go from buying the rumor to selling the news?
Haviland: We live in a cyclical economic system; we have a cyclical stock and bond market. When you look at the average length of time between recessions, it's about five years in the 20th century.

Now, the low end of that is measured in months, and the high end is 10 or 11 years. Right now, we're almost eight years into this bull market. It's getting old.

At some point, it doesn't become pessimism to prepare for the inevitable, it becomes realism. And that's what we ask people to consider. Just be ready. Does some of your portfolio have that ability to get defensive?

Contact Cinthia Murphy at [email protected]