Strategies that rotate typically allow an investor to maintain a target asset allocation but to rotate within a particular asset class.  In other words, it does not answer the question, “Should I be invested in a particular asset class?”  Instead, rotation attempts to answer the question, “Within a particular asset class, which sector, style, factor, or geography should I invest in?” While rotation most obviously applies with equity asset classes, it can also be effective within fixed income. This would include rotations between Treasuries and High Yield, or between long duration and short duration.

Strategies that tilt focus on the relative relationships between asset classes. Tilting strategies assume there are opportunity sets of asset classes with a target asset allocation. Tilting attempts to answer the question, “Which asset classes should I overweight and which asset classes should I underweight?”  This includes shifting allocation from U.S. Equity to International Equity or tilting exposure from Commodities to REITs. It could also include tilting away from the target allocation between stocks and bonds.

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We define strategies that hedge as those that remove the exposure to the asset class. This is different than “tilting,” which moves the exposure to a different asset class. This definition of hedging is the proverbial “in or out” question—should I be in a particular asset class or not? If the tactical answer is “no,” then the manger, advisor, or the ETF itself may incorporate short positions, risk overlays, or actually move to cash.  The consequence of being right or wrong are more pronounced in strategies that hedge because there is no embedded “beta” to a particular asset class.

In reality, there are not bright lines between strategies that rotate, tilt, or hedge. In fact, many strategies incorporate combinations of two or even all three. True diversification would suggest paying attention to all three types of strategies. Episodes of downside volatility will be with us over any time frame that purports to build wealth through investments. ETF strategies that rotate, tilt, and hedge may offer valuable opportunities for upside capture and downside protection.

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