Three ways tactical asset allocation can help build wealth
Written in partnership with globeinvestor.ca (Globe Content Studio)
Date: June 1
When markets are volatile, investors need more than a plan that’s set on autopilot.
If there’s one word that describes the markets this year, it’s volatility. Unlike in 2017, stock prices have been bouncing up and down, while the CBOE Volatility Index, a key measure of market volatility is up almost 63% year-to-date.
While investors are typically told to invest for the long-term, that doesn’t mean they shouldn’t adjust their portfolios in more turbulent times, some experts argue. Adjusting, though, is not day trading – it’s making small tactical asset-allocation decisions to take advantage of parts of the market that may be undervalued or offer better opportunities. For example, if Europe’s economy starts taking off and equities there look more attractive, then an investor may want to move some of their U.S. allocation overseas.
“Like a pilot, investors need some flexibility to take over the controls,” says Kathrin Forrest, Portfolio Manager, Sun Life Global Investments. “If there’s a thunderstorm ahead, you may need to make some different decisions to make sure you can make it to where you need to go.”
Unlike strategic asset allocation, which is more focused on long-term market expectations, tactical asset allocation is an investment strategy where a manager or investor adjusts a portfolio’s mix to try to improve shorter-term returns. It’s about making small shifts, over several months, with the hopes of adding incremental return.
“You look beyond the headlines and try to understand the risks and opportunities,” she says.
The renegotiation of the North American Free-Trade Agreement (NAFTA), and the potential risk that U.S. protectionism presents to certain sectors of the Canadian economy, are two of the issues that’s caused Ms. Forrest and team to make a tactical move. Over the past few months, they’ve moved some of their funds’ assets out of domestic equities and into U.S. stocks. And Ms Forrest says they’ve also added to high-quality Canadian bonds.
Seeing the big picture
Tactical asset allocation decisions are often made by looking at broad economic factors, such as global growth rates, valuations across different markets, monetary and fiscal policy, as well as market sentiment, says Pauline Shum-Nolan, a professor of finance at York University’s Schulich School of Business in Toronto.
“It’s an active strategy that tries to add value by overweighting certain asset classes that are expected to outperform in the near term and underweighting others that are expected to underperform,” she says. “It’s about forecasting, but at a macro level, rather than trying to predict how individual companies are going to perform.”
While savvy investors may be able to do this on their own, most people will probably be more comfortable leaving those decisions to professional fund managers who study global economies and markets and have the capability to sell assets in one area and buy in another. For those who choose to make such a move, there are three ways tactical asset allocation can help a portfolio.
Managers make tactical decisions to capture opportunities, rather than just to avoid risk. Ms Forrest’s decision to underweight Canada and overweight the U. S. is an example of playing offence – better opportunities could exist in the U. S. due to strong economic fundamentals and tax cuts that have boosted consumer and business confidence.
“You want to make sure that you capture the potential upside from the broader fundamentals,” Ms. Forrest says. “You want to seek additional returns. That means putting your money where you get the best reward for the risks you’re taking.”
Saying that, tactical moves can be made to potentially protect a portfolio from losing money. For instance, although Ms Forrest may be finding more opportunities in America than Canada today – hence the shift to U.S. equities – she has also added safer, high-quality Canadian bonds to protect against increased market volatility.
Ms. Forrest describes it as investing at a crossroads.
“You want to make sure you capture that potential upside from the broader fundamentals that look very strong, but you also want to protect the downside,” she says.
Tactical decisions also come in handy when market cycles start to shift, Prof. Nolan-Shum says. If the business cycle is on an upswing, investors might allocate more of their assets to growth stocks instead of value plays and then move back to value when that cycle reverses.
“It’s all about making the right bets,” Prof. Nolan-Shum says. “It boils down to forecasting and how well you’re able to systematically predict [what the market will do].”
It’s likely that market volatility is here to stay, Ms. Forrest says. She points to the market’s recent gyrations on a combination of rising interest rates and inflation, as well as policy uncertainty.
Fortunately, volatility is not necessarily a negative.
“It creates opportunity for asset management, including tactical asset allocation to enhance risk-adjusted returns,” she explains.
Ultimately, being tactical can provide a smoother ride as markets rise and fall. That, in turn, gives investors more confidence that they can weather the storm.Says Ms. Forrest: “It’s about making sure that we tap into every opportunity out there to generate returns.”