Description

Tactical asset allocation is the practice of fine-tuning an investment portfolio to meet changing market conditions. This article discusses the use of ETFs when implementing a tactical asset allocation strategy.

Synopsis:

Stocks and bonds are the fundamental building blocks of any investment portfolio. The types of stocks and bonds on which you choose to focus your portfolio will indelibly stamp your future investment performance. The blueprint for this focus is called the master asset allocation plan, and many argue that it represents the single most important decision that can be taken in an investment program. A well-constructed portfolio carries out the objectives of the investor by adhering to its preordained allocation formula. However, many portfolio managers have found they may enhance performance by adapting their allocation formula as the market environment changes, a practice often called tactical asset allocation. Exchange-traded funds (ETFs) can be a powerful tool for building and maintaining a portfolio that rigorously meets investment objectives while at the same time flexibly adapting to the changing dynamics of the market. This article discusses the use of ETFs when implementing a tactical asset allocation strategy.

Key Points

Exchange-traded funds (ETFs) may be ideal tools for helping savvy investors execute 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 starts with an assessment of the investor’s 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. An investor can often identify these individual patterns and use that insight to guide his or her investment processes — shifting value to an investment that might outperform the average from an asset type showing potential to lag behind broad market performance. ETFs can provide a high degree of precision in targeting the exact proportions needed for an 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 environmental 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 Financial and Economic Cycles

Tactical asset allocation is active asset reallocation — that is, changing your investment mix in response to actual environmental 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 the stocks of companies in a specific economic sector. Niche-focused ETFs can be used to increase your investment exposure to just those asset categories that might be needed to implement your short-term strategy.

Market Dimensions That Can Be Exploited by ETFs

Growth and Value

The relative performance of growth stocks and value stocks historically has been dependent on the market cycle. Growth stocks often have made their greatest gains in the early stages of a bull market, while value stocks have produced stronger appreciation as a bull market ages. In fact, during three of the past four times since 1978 that a bull market has entered its third year, the value component of the S&P 500 outpaced the growth component on both a percentage change and frequency of out-performance basis. ETFs that are composed purely of growth or value stocks can be used to add weight to one style or the other selectively.1

Earnings and Market Cycles

Bull markets are traditionally marked by rising stock prices and increasing stock valuations. In fact, valuation — the amount of money that an investor is willing to pay for a dollar of expected earnings — is often a closely watched indicator of a potential turn in the direction of the market. Valuation is measured by a statistic known as the price-to-earnings ratio (P/E). As seen in the chart that follows, the level of P/E in the market is often associated with a change in direction. This often indicates the extent to which stocks might become overvalued or undervalued. (It should be noted that P/Es tend to be higher today than they were 50 years ago, so the levels of the next peaks and troughs might be expected to be higher than the simple averages might otherwise predict.)

Investors concluding that stocks have become overvalued may seek to reduce the proportion of equities in their portfolio by increasing the percentage of assets committed to bonds; when stocks are undervalued, they seek the reverse. ETFs that mirror the broad equity and bond market allow an investor to shift this emphasis quickly and efficiently.

The Potential Value of Sector Rotation

Economists divide the economy into broad sectors — groups of similar industries that tend to demonstrate similar business dynamics. Some of these sectors have demonstrated distinctive patterns of performance during the year. An investor who added the right sector ETF could have enhanced returns proportionately. For example, during the 15-year period from January 1997 to December 2011, Consumer Staples and Health Care have generally performed stronger in the warmer months of each year, on average, and trailed in the cooler periods (a pattern opposite most other sectors). An investor who disproportionately increased either of those sectors in his or her portfolio may have had the opportunity to boost returns accordingly.2

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.

Successful implementation of a tactical allocation plan may require more attention to maintenance than a static portfolio. Turnover — selling one asset while simultaneously buying another — tends to be costly. Commissions and fees can be considerable, and a reallocation transaction can create a capital gains tax liability. To minimize turnover (and its attendant costs) many investors try to change their asset mixes only when they add assets to their portfolios or when forced to sell a holding for some other reason. 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

  • 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.
  • Exchange-traded funds (ETFs) allow an investor to realign allocation by adding precisely the asset class, style, and amount needed to achieve any desired effect.
  • Tactical asset allocation can involve changes in the mix between stocks and bonds, or changes in the mix of types of stocks and bonds.
  • Some forms of reallocation are tied to economic changes, some to stock market cycles and some to interest rate changes.
  • Turnover can be costly, therefore many investors try to change the asset mix within their portfolio only when they add assets or when forced to make a change for tactical reasons.

Source/Disclaimer:

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.

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© 2012 McGraw-Hill Financial Communications. All rights reserved.

March 2012 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by D3 Financial Counselors, a local member of FPA.