1) Bullseye
Highlights
Tactical Diversification
The idea of tactical diversification seems like a contradiction in terms because the two words, tactical and diversification, have
long been perceived as opposites. Diversification relies on a buy-and-hold approach based on long term averages, whereas
tactical strategies tend to be adaptive and ever-changing based on shorter term data. Tactical diversification is where these
two ideas intersect by turning conflicting approaches into complementary strategies. Asset class diversification has been a
major tenet of portfolio structure since Modern Portfolio Theory was introduced by Harry Markowitz in the early 1950s. This
philosophy is rooted in the common sense practice of not putting all of your eggs in one basket. Strategic asset allocation uses
a buy-and-hold approach to diversification by looking at long-term historical risk/return data to create an optimized portfolio.
This optimization process tends to look at long-term averages while ignoring short term performance swings. If an investor
has a time horizon of 20 or 30 years, then they should be willing to endure the short term volatility of the markets.
Unfortunately, the philosophy of strategic asset allocation rarely aligns with the reality of an investor’s emotions. Short-term
swings are a reality that investors must face, making it hard to see the long-term picture. It is hard for some investors to simply
ignore the fluctuations in their account values in hopes that allowing more time will solve the problem. If time were always
the perfect cure, then there really would be no need for diversification. An investor could simply choose an investment with
the best long-term performance history and ride out the volatility. But long-term averages can mute the reality of short-term
swings. And as we all know, there is no guarantee that what has performed well in the past will continue to perform well in the
future. Instead of static portfolios, some investors embrace the idea of tactical asset allocation, which involves a more adaptive
approach. This should not be confused with market timing or high frequency trading. Rather, it is an active strategy which
focuses on identifying what is currently working well in general and building a portfolio mix that seeks to capitalize on it. As
with most investments, tactical asset allocation strategies have their periods of strength and weakness—no strategy works all
the time in every market environment.
A popular tactical approach is to use a
trend-following strategy such as relative
strength. The idea is start with a defined
universe of securities and to invest in
those that are doing well relative to the
others. Then, when the market changes,
the portfolio moves to the investments
showing strength. The strategy involves
staying with winners until they start to
lag, then shifting to a new investment.
Momentum strategies are similar to
a relay race, with periods of dips and
surges. As one runner tires and slows
down, pass the baton to a new runner.
Momentum strategies “pass the baton”
as an investment loses strength and the
portfolio shifts to a new investment.
Relative Strength “Passes the Baton”
Investment
“B”
Investment
“A”
Buy “A”
based on
strength
Sell A & Buy B
as strength
momentum shifts
Hypothetical, for illustrative purposes only.
2) Many investors like a momentum-based approach because it is systematic and does not allow for a decision making
process subject to speculation and emotions. But that is not to say that it always works. We all know that even the fastest
runner has the potential to stumble. Relative strength strategies do have their periods of pullbacks, which is to be expected,
especially as momentum shifts and market leadership changes. As a new trend is established, the portfolios must go
through an adjustment period during the transition to the new areas of strength—in other words, the slow down period as
the runners pass the baton. Choppy or trendless markets can also lead to periods of underperformance until new market
leadership is established and a new trend develops. A pure “go anywhere” relative strength strategy may be appealing to
investors with a higher risk tolerance, especially when they understand the natural ups and downs of the strategy.
Strategic diversification and tactical strategies have long
been viewed as opposing philosophies. Investors have
historically faced a line drawn in the sand, having to decide
which side they believe in more strongly. But there is an
approach which has a common middle ground—tactical
diversification. By combining the common sense tenets of
diversification with the practical approach of adaptability,
tactical diversification seems to be at the intersection of
both strategic and tactical portfolio construction. What
were once perceived as conflicting approaches, when
combined, may actually be quite complementary.
Consistent with Modern Portfolio Theory, a tactically
diversified portfolio should rely on a blend of multiple
asset classes such as stocks, bonds, commodities, and real
estate (REITs). Taking a global approach, using both U.S.
and international investments, may further enhance the
potential for diversification. Based on historical modeling,
a range of exposures may be established for each major
category to allow for some flexibility. But the idea of
diversification is to maintain at least some exposure to each
category at all times.
Then, to allow for adaptability, a relative strength approach
can be applied within each category. For example, if a
portfolio is designed to maintain a constant exposure to
stocks, it does not have to include all stocks. There are
times when certain stocks, sectors or styles outperform.
The idea is to recognize that markets are dynamic and there
is a potential value in being adaptive.
Tactical Diversification:
Modern Portfolio Theory Meets
Newton’s Laws of Motion
Tactical
Strategy
Adaptive
allocations that
adjust to shorter
term market
environments
Tactical
Diversification
Diversified
Strategy
Constant
allocations to
multiple asset
classes based
on longer term
market averages
Diversified strategies stem from Modern
Portfolio Theory and the idea of blending
multiple asset classes. Tactical strategies,
such as relative strength, use the theory
of momentum where an object in motion
remains in motion until an outside force
acts upon it. Tactical diversification relies
on both theories. Harry Markowitz, meet
Sir Isaac Newton.
So, how can this tactical philosophy be applied within a diversified portfolio? A tactically diversified portfolio may apply
a relative strength measurement within each asset class in an attempt to identify which specific investments are currently
performing the best within their market segment. On a higher level, the portfolio may also apply a second layer of relative
strength at the asset class level to overweight and underweight the allocations within a predetermined minimum/maximum
range. The result is a portfolio with constant exposure to a diversified set of asset classes, but with the ability to adapt to
ever-changing market environments.
Past performance is not indicative of future returns. Historical data may be used for illustrative purposes only and
should not be used as a predictive measure for the future return expectations of any investment. This information is based
on hypothetical strategies and should not be construed as a recommendation of any specific security or investment product.
The information was prepared without regard for specific circumstances and objectives of any individual investor. Traditional,
alternative, tactical and diversified investments all involve risks, including the potential for loss of principal. None
of the investment strategies discussed are able to guarantee positive returns over any time period. Before investing
in any financial product, always read the prospectus and/or offering memorandum for general and product-specific risks.
0565-NLD-2/7/2014