Tactical Strategies
June 28, 2011
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Conventional wisdom among investment professionals has been that the best way to reduce portfolio risk is to adopt a diversified long-term strategic asset allocation. That paradigm was challenged – deservedly so – following the 2008 financial crisis. Fortunately, an improved paradigm has emerged: Investors should combine long-term strategic allocations with a value-oriented tactical rebalancing strategy.
I will explain how that approach insulates investors from the severe market declines they faced in 2008, but first let’s look at how diversification and periodic rebalancing of portfolios back to their target strategic weights failed so miserably.
Diversification and static rebalancing put to the test
Under a strategic asset allocation strategy, an investment professional works with his or her client to determine the client’s investment objectives and risk tolerance. The professional then selects various asset classes and formulates a particular portfolio allocation that likely will produce a long-term return and volatility that matches the client’s risk tolerance and specific objectives. In determining the portfolio’s asset class mix, the professional selects asset classes with returns that are unlikely to move in conjunction with each other during given market conditions (i.e., they have a low or negative correlation of returns).
This diversification is designed to increase the risk-adjusted returns of the portfolio since portfolio’s made up of asset classes with low return correlations have historically produced higher annualized returns with lower volatility compared to similar but less diversified portfolios. Once the portfolio’s long-term or “strategic” allocation has been established, the professional implements the allocation by selecting individual investments for each asset class. These investments can be passive in nature (such as mutual funds or exchange traded funds that track market indexes), or they can be active in nature (such as actively managed mutual funds, private money managers and/or hedge funds). In some cases a professional will blend the two by investing in both active and passive investments.
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