As fiduciary financial planning and passive asset management eclipsed old-fashioned stock picking, a growing number of financial advisors turned to asset allocation based on the efficient-market hypothesis.
This hypothesis is based on the idea that share prices reflect all publicly available information and that it’s impossible to consistently and persistently generate a return above the broader market.
But does increased equity market volatility combined with the underperformance of bonds relative to their historical performance mean it’s time for a more tactical approach? Tactical investing is an active portfolio-management strategy that changes the percentage of asset class categories to capture current market strength or mispricing.
That’s in contrast to the efficient-market hypothesis, which states that it’s impossible to outperform the market systemically, as mispricings don’t persist.
“The last year has shown that passive asset allocation is not immune to market drawdowns,” says Andrew Pesco, head of investment management at Domain Money in New York.
He points out that the classic 60/40 portfolio, as represented by the Bloomberg 60/40 index, is now down more than 12% from its peak Dec. 27, 2021.
“To put that in context, the 60/40 portfolio has returned 5% on average over the last 100 years, so this drawdown has erased more than 2 years of average returns,” Pesco says. “These drawdowns provide opportunities for selective investors to deploy capital to investments in both technology stocks as well as crypto.”
Other advisors and asset managers agree that current conditions are not optimal for traditional strategic portfolio construction.
“We believe a tactical allocation better serves clients than a strategic allocation,” says Loreen Gilbert, founder and CEO of WealthWise Financial Services in Irvine, California.
“Right now it is a stock pickers’ market and not an indexing market. Tactical allocations can have better outcomes for clients if the tactical moves are the right ones,” she says.
Decreasing Portfolio Risk
Since the beginning of the year, Gilbert has decreased international exposure and the duration of fixed income in client accounts. Meanwhile, she boosted the weighting of value stocks, as well as hedged positions, and cash and commodities. Those moves also served to decrease the portfolio beta, or the measure of its overall systematic risk.
While portfolios with a static allocation to investment-grade bonds have seen significant losses due to rising rates, more dynamic portfolios can reduce exposure to those bonds in favor of other instruments that appreciate more with inflation, says Nadia Papagiannis, senior vice president of multi-asset-class solutions at Northern Trust in Chicago. Those include Treasury inflation-protected securities and high-yield bonds that have less interest-rate sensitivity.
Papagiannis adds that Northern Trust Asset Management also repositioned the equity side of clients’ portfolios during this volatile and inflationary period by overweighting U.S. companies, which are less affected by the Russia-Ukraine war than international stocks. The company has also overweighted the portfolio in natural resources stocks, which have historically protected against inflation better than other asset classes and are a source of high income at the moment.
“While growth stocks fared well in 2019 and 2020, investors still exposed to them through static portfolios are being hurt by their significant underperformance versus the broader stock market,” Papagiannis says. That’s due to rising rates and inflation, which favor value and dividend-yielding stocks. Tactical portfolios were able to make appropriate adjustments to changing conditions.
That’s not to say every tactical approach is right for the current market. For example, Papagiannis notes that simply switching out ETFs in different U.S. stock market sectors may only serve to increase transaction costs and tax liabilities for investors, without adding significant portfolio value over time.
“Factor-based investing, or seeking stocks with value and quality dividend characteristics, is more effective, according to our research,” she says. “We also don’t favor drastically changing a portfolio’s risk profile. An example of this is reducing risk by going into cash, which could result in mistiming the market and missing out on recoveries.”
Of course, even in a downturn, it can literally pay to scout out investments with the potential to rise once the trend reverses.
Opportunity in a Downturn
“In the equity market we see significant opportunities to deploy capital toward companies building indispensable technology with large addressable markets, great leadership teams, and that continue to compound growth and capital at elevated rates, even through the recent period,” Pesco says. “Many of these businesses are trading 30% to 70% down from their all-time highs and trade at the lowest valuation multiple in years.”
Pesco, whose company specializes in crypto investment, says Domain Money’s research shows that investors should consider allocating anywhere from 0.75% to 6% of their liquid portfolio into a basket of cryptocurrencies. He says the specific amount would depend upon an investor’s time horizon and risk tolerance.
“Given the recent drawdown in crypto prices, we think that the current environment is particularly favorable to making a long-term allocation,” he says.
However, he does have one caveat for those wanting to implement a tactical approach.
“Our philosophy is that investors should not over-trade their portfolios. Drawdowns, especially of the magnitude of the recent market moves, are hard to stomach, but staying invested is a key determinant of long-term investment success,” he says.
Pesco adds that investors should expect long-duration assets such as technology stocks to exhibit heightened volatility during times of uncertainty.
“That said, we actively monitor our existing investments and are constantly seeking attractive entry levels to buy companies and cryptocurrencies that will be tomorrow’s leaders,” he says.
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Does Market Uncertainty Mean It’s Time for a Tactical Investing Approach? originally appeared on usnews.com