Is Your Portfolio Out of Balance? Why ETFs Are a Game Changer

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Any return-seeking portfolio requires accepting elements of risk. Market risk is broadly defined as the risk associated by simply owning a specific asset class. This might be referred to as “market beta,” or the return associated with the market. Strategy risk is broadly defined as the risk associated with a decision that would move the portfolio away from simply owning a particular asset class weighted according to its market capitalization. These strategies would include passive, alternative weighting approaches (smart beta) in addition to active, tactical management.

It is important to balance “market risk” and “strategy risk” within portfolios.  Some market forecasters have expressed concern about projected market returns. This implies less confidence in the reward associated with the level of risk embedded in a particular asset class. This may suggest a need for additional strategy risk within that asset class.  As with market risk, strategy risk comes in all shapes and sizes. Some strategy risk has a high degree of embedded “beta” (this includes some “smart beta” strategies), while some strategy risk may have times with low or no “beta” (strategies that can significantly reduce or leave asset classes).  The ability to withstand negative variation from a market benchmark should guide the amount of strategy risk introduced into a portfolio. This recognizes that transferring risk from market risk to strategy risk does not eliminate risk. Instead, the risk simply changes form.

A foundational principle of diversification is combining asset classes and sectors that do not always move in tandem with each other. In other words, building a portfolio with assets and strategies that have lower correlations to each other. It is noteworthy that correlations are not static, and they will look different across time periods. There is concern among investors about increasing correlations across some asset classes. However, correlation does not capture magnitude. Two asset classes may be highly correlated, but Asset Class A is up 2% and Asset Class B is up 20%. Including a combination of both in a portfolio may make sense, despite the high correlation.

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It is essential for investors to find the right balance between “offense” and “defense” within their portfolios.  Combinations of asset classes and strategies can be formed to create growth-oriented allocations, principal-protection allocations, and everything in between. While the “right balance” is unique for each investor, the ETF tools used to achieve this balance are widely available. Creating balance is within reach if the ETF tools are used correctly.

As an example, I have two teenage daughters that play soccer. One plays forward, while the other plays keeper.  Their respective roles are both important, but are very different. It would lead to disappointment if the team expected my goal keeper daughter to score goals. Likewise, an expectation that my daughter playing forward could regularly stop shots on the goal would be unrealistic. Investors expecting their defensive allocations to score points will be disappointed. It may result in replacing truly defensive allocations (that will not score many points) with defensive allocations that are really disguised as offense. This masquerade can also take place in the growth or offense-oriented portion of the portfolio.

If you have lost portfolio balance, it is time to get it back! What may have been the right balance a year or two ago may have changed. Market currents and tides are ever-changing, which requires a continual search for the right investment balance. Fortunately, we have a seemingly endless array of ETF tools to help us all to strike the right balance.

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