By John Lunt, President, Lunt Capital Management, Inc.
There is always a “wall of worry” for financial markets to climb. Today, investors rightly worry about how trillions in monetary and fiscal stimulus will impact inflation, interest rates, economic growth, company earnings, and equity valuations. Recently, I wrote an article about the importance of preparing investment portfolios for multiple scenarios in the face of uncertainty. Going further back in the archives, an article I wrote in August of 2017 about strategy diversification could have been written for today’s market. Here is an excerpt:
“The principal of diversification drives asset allocation for both institutional and individual investors. The benefits of diversification do not come from simply adding more investments to an asset allocation, but rather, from adding investments with lower correlations to existing investments within the allocation. However, a prospective investment may have a higher correlation to existing investments, while still bringing desirable attributes like the potential for lower volatility, downside protection, or upside outperformance. Ultimately, investors hope to generate more return per unit of risk. Return requires risk, and we believe that risk is either derived from the asset class (market risk or market beta) or from the manager (strategy risk).
Today, many investors are concerned about how public policies (particularly monetary policy) have distorted returns for both equities and fixed income. This has raised concerns about potentially high valuations for equities while at the same time fueling worries about the potential for rising rates and widening credit spreads in fixed income. In short, investors are worried about “market risk.” With heightened concerns surrounding market risk, it seems natural for many investors to seek additional ways to diversify portfolios. In this quest for diversification, investors may ask: what does not necessarily correlate with market risk or market beta? The answer: active investment decisions or investment strategy.”
In our view, diversifying by strategy is an essential element in building and managing investment portfolios. While there is almost an endless list of potential investment strategies that could be used, I will highlight four broad strategy buckets that could serve as building blocks within long-term investment portfolios.
Strategy 1: Innovative and High Conviction Growth Bucket
These strategies do not ask the question “Should I be in or out of equity markets?” but rather these strategies ask the question “Which segments of equity markets should I invest in and how should I do it?” In other words, this portion of the portfolio stays fully invested at all times, and acts as the portfolio’s growth engine. We believe that Innovative and High Conviction Growth strategies should look very different than simply “owning the market.” We prefer strategies in this bucket that express an opinion and that are inclined to be dynamic, focused, or both. This can encompass thematic strategies, rules-based rotational strategies, and active strategies. This bucket does not simply focus on the “growth style.” Instead, it is a bucket with a growth objective, and may include a wide array of strategies, including growth, value, dividend, or innovation-focused strategies. It certainly includes our favorite strategies- Lunt Capital Factor Rotation Strategies!
Strategy 2: Risk On – Risk Off Growth Bucket
These strategies attempt to answer the questions “Should I be in or out of equity markets?” or “Should I increase or decrease my exposure to equity markets?” This bucket attempts to add growth and improve portfolio compounding over time by reducing downside during market declines. This bucket includes rules-based, tactical, “in or out” strategies that use broad asset class ETFs, factor ETFs, sector ETFs, or country ETFs. These strategies may move in or out of their investment universe to varying degrees based on a range of inputs, including quantitative, qualitative, macro, or discretionary triggers. This bucket also contains downside hedging strategies from the growing list of ETFs that use options overlays, hedge fund replication, rotations to cash, or tail risk strategies. In additional, the rapid rise of target outcome strategies with a mixture of caps and buffers may be valuable tools within this bucket.
Strategy 3: Opportunistic Growth and Income Bucket
This bucket does not require dedicated exposure to asset classes or investment categories. Instead, it searches for opportunities wherever they might be found. It allows for positions that might exploit market inefficiencies, imbalances, or mispricing. This is also the bucket that can be used to capture developing themes or market trends. While the Innovative and High Conviction bucket requires long-term, steadfast dedication to a position or strategy, positions in the Opportunistic bucket typically have a defined thesis and horizon. Investments like gold, foreign currencies, bank loans, and high yield bonds may not have a dedicated allocation within the portfolio but may be attractive to own opportunistically for certain periods of time. An allocation in the Opportunistic bucket is not constrained by a specific time frame. The opportunity may appear and disappear relatively quickly, or it may require a longer time frame to blossom.
Strategy 4: Risk and Volatility Reduction Bucket
The Risk and Volatility Reduction bucket is designed to play defense rather than produce return. The Risk On – Risk Off Growth bucket attempts to reduce downside but is still return seeking. In contrast, the Risk and Volatility Reduction bucket has very modest return objectives. Historically, this bucket would be allocated almost exclusively to fixed income strategies. This bucket likely includes a large dose of higher quality, lower duration fixed income strategies, but additional allocations that focus on TIPS, mortgages, and international sovereign debt may be appropriate. There has been tremendous growth in active fixed income strategies within ETFs. In fact, some of the world’s most talented fixed income manager offer their active strategies inside ETFs. In addition, rules-based, dynamic fixed income strategies often find a home in this bucket.
It is worthwhile noting that risk is not eliminated by incorporating “strategy” into the portfolio. Rather, risk simply changes form from market risk to strategy risk. In a time of heightened concern about market risk, introducing a variety of investment strategies has the potential to enhance total portfolio diversification. Investment strategies might be exactly what is needed to move around, over, or even through the market’s wall of worry.