Note: This article appears on the ETFtrends.com Strategist Channel
By John Lunt
Diversification has become an accepted, foundational principle for constructing investment portfolios. In many cases, discussion around diversification centers on incorporating multiple asset classes into an investment portfolio in order to enhance the overall risk/return profile.
In our view, strategy diversification is an additional, important investment tool for constructing portfolios. Investors of all sizes are recognizing the value of combining strategic allocations with tactical management. Some within the financial industry mistakenly suggest it is an “either-or” investment world. That is, investors must either choose passive, strategic allocations or they must choose active, tactical allocations. This is a false choice. Asset class and strategy diversification allows us to build portfolios in an “and” investment world, where we can embrace both strategic and tactical allocations. Strategic (often passive) allocations derive return by accepting market risk. Tactical portfolios derive return by accepting strategy or active risk.
Tactical management has always been part of our investment DNA at Lunt Capital. Tactical management is often thought of as a risk management tool with the potential to reduce volatility and protect capital. Tactical management may also offer the potential to act as a portfolio growth engine by capturing unique investment returns. Tactical management offers the potential to protect against downside market risk and capture upside market returns, but it is important to recognize tactical management has not eliminated risk. Instead, risk has simply changed form, from market risk to strategy risk.
Related: ETF Investing in the World of the Impossible and Inevitable
By design, tactical management looks and behaves differently than strategic, passive investment allocations. These differences are sometimes misunderstood, and the ability to effectively extract returns through tactical management requires sustained commitment. Because tactical strategies behave differently than popular investment benchmarks, it is important to determine for how long and by how much an investor will allow a tactical strategy to underperform against an appropriate benchmark. A significant risk for investors that utilize tactical strategies is not that the tactical strategy does not work, but rather that the tactical strategy is inappropriately benchmarked, leading to false comparisons or expectations.
Tactical management is an important tool in the risk management of individual securities, asset classes, and even as an overlay at the total portfolio level. Tactical strategies that reduce exposure to underperforming asset classes offer the potential to reduce volatility and protect against significant portfolio downside. Downside protection is essential for investors with finite horizons, as the sequence of returns becomes particularly meaningful. It may be impossible or difficult to avoid some drawdown or losses in investment portfolios, but the potential for tactical management to cushion drawdowns may make the difference as investors attempt to weather inevitable pullbacks and market volatility.