Note: This article appears on the Strategist Channel

By John Lunt

Recently I had the opportunity to talk about asset allocation with a talented financial advisor. We discussed ideas about combining asset classes and strategies in the optimal way to meet the needs of his clients. As we reviewed whether a particular exchange traded fund (ETF) strategy would be appropriate, I asked him, “What question do you expect this ETF strategy to answer?” 

Was the strategy trying to answer question one: “Should the portfolio be in the asset class or not right now?”  or was the strategy trying to answer question two: “What segment or sub-component of the asset class should the portfolio be in right now?”

Notice that question one is an “in or out” question. Strategies that tend to answer this question focus on compounding returns over time by limiting the downside of a particular asset class. We would expect the potential to be “out” of the market would lower volatility and lower drawdown over time, but it would also result in times of being “out” during rallies in the asset class.

The second question does not try to answer the question of “in or out”— it is assumed it remains “in” the market. Instead, this question is about “rotation,” and an attempt to identify the optimal exposure within the asset class. Question two is structurally designed to compound returns by focusing on the upside. It may reduce volatility or drawdown by rotating to segments that are declining less, but it always stays invested. There are excellent ETFs and ETF strategies designed to answer question one or question two. However, a strategy designed to answer the “rotation” question cannot be expected to answer the “in or out” question.

Related: Picking the Right Club for the Next Shot in ETFs

Answering these questions highlights the importance of understanding design when selecting ETFs or ETF strategies. The design will determine the characteristics and attributes of a particular strategy. From our perspective, most ETFs and ETF strategies are portfolio “tools” that are well designed. It becomes important for the advisor or manager to use the tool correctly for the benefit of the client. There are other important design questions for advisors or investors to ask. We suggest asking questions related to opportunity set, strategy goal, and time frame. Answering these questions will ultimately help an advisor understand the economic and market conditions during which the strategy is expected to perform well. Just as importantly, it helps the advisor understand the conditions during which the strategy may perform poorly. Make no mistake, there is no ETF or ETF strategy that will perform well at all times under all market conditions.  Successful portfolio construction requires a correct understanding of tradeoffs between carefully designed strategies.

The strategy “opportunity set” is simply the universe of potential investments. Will the tactical opportunity set be broad (i.e., value or growth) or targeted (i.e., sectors or industry groups)? Will there only be a few options to select from or will there be many options to select from? Large, diverse opportunity sets may offer dramatic dispersion and more opportunities to outperform or underperform, and they are also likely to lead to more trading.  Smaller opportunity sets may show less disparity in returns but also result in less frequent trading.  Both types of opportunity sets are useful, but they will likely result in different strategy characteristics.

Related: Have ETF Investors Misjudged the Influence of Central Banks?

Understanding the design behind the strategy “goal” is essential in identifying market conditions under which the strategy is expected to succeed or struggle. For example, does the strategy have the goal of capturing changes in trends (contrarian) or the goal of capturing continuation of trends (momentum)? Both are attractive goals, but contrarian strategies may get in too early (the risk of identifying a false turn) while momentum strategies may get in too late (the risk of identifying a trend after a large part of the move is over).

Is the strategy’s time frame short-term or long-term? Understanding the design behind time frame is potentially the most misunderstood question. Strategies that capture short-term moves may be unsuccessful in capturing long-term moves, and vice versa. Profiting from short term moves will require a strategy to have very sensitive triggers, while capturing long-term moves typically requires less sensitive triggers. Strategies with a sensitive trigger typically get in a major move in the early stages, but these strategies are also susceptible to more frequent false or “whipsaw” moves. A less sensitive trigger will often result getting in or out later, but it will typically filter out short-term noise and trade less. There are advantages and disadvantages to both short-term and long-term strategies—the design simply needs to properly match the expectation and objective.

Related: March Madness: What Investors Can Learn From Picking Brackets

Finally, investors and advisors need to answer the most important question: “How much negative variation from a benchmark is acceptable and for how long will negative variation from a benchmark be tolerated?” Positive variation from a benchmark is desirable and welcome. Long-term outperformance over a benchmark typically requires a willingness to look very different from a benchmark. Periods of outperformance may be followed by periods of underperformance. Patience to look different from a benchmark is a critical design question—less tolerance for variation from a benchmark will result in looking more like the benchmark. An investor expecting outperformance must accept a strategy design that leads to behavior very different (up or down) from the benchmark. One of the reasons that many advisors and their clients do not outperform their benchmarks is that they do not allow carefully designed strategies to do exactly what they are designed to do—which is to look different!

When investors and advisors want answers from their portfolios, they should begin by making sure they are asking the right questions.  In the end, it is all a question of properly matching design with objective.

John Lunt is the President of Lunt Capital Management, a participant in the ETF Strategist Channel.

Do NOT follow this link or you will be banned from the site!