Note: This article appears on the 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.

Related: Asking and Answering the Right Questions for Your ETF Portfolio

Tactical management offers more than simply the ability to protect. Importantly, tactical management strategies may offer the potential for growth and outperformance relative to market benchmarks. Tactical can play the role of portfolio growth engine by utilizing strategies that overweight or emphasize securities, sectors, or asset classes.  Too often, tactical is viewed simply as a tool used to identify what to avoid or when to sell. Tactical can also be useful in identifying what should be owned and when to buy. Strategies that only focus on “exiting” the market are not sustainable, as investors will ultimately desire to re-enter markets. Tactical can be important in the persistent investment search for growth opportunities.

It is worth noting that Exchange Traded Funds (ETFs) have transformed the ability to create and implement tactical strategies. ETFs have opened up access to asset classes and sub-asset classes (diversified market “beta”) that were previously the domain of only the largest institutional investors. ETFs provide transparent, targeted access to a wide variety of markets, segments, sectors, and factors.

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

ETFs create efficient, cost-effective market exposure that allows value creation through the tactical management of diverse market betas.  In the past, the primary focus of many investors was individual stock selection (Should I own Chevron or Exxon?). At Lunt Capital, we do not focus on differences between individual companies within the same sector that often exhibit high degrees of correlation.  Instead, we focus on creating value by targeting specific sectors, segments, asset classes or factors (Should I own energy companies or technology companies?  Should I own U.S. stocks or Emerging Market stocks?  Should I own stocks exhibiting lower volatility or stocks exhibiting momentum?). It would be difficult or impossible to tactically answer these questions without ETFs.

Tactical strategies are a valuable investment tool that can be utilized for protection or growth within portfolios. ETFs have opened access to tactical strategies to all types of investors. Tactical ETF strategies have transformed investing—this is an important tool that cannot be ignored.

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

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