The importance of being tactical

Amid growing market volatility & muted return expectations, investors may benefit from a more tactical approach

When it comes to investing, you can think of your strategy like running a marathon. It requires goal-setting and a long-term game plan. But you also need to be flexible enough at times to deal with fast-changing scenarios – this is where smart tactics come into play. Being tactical is less like marathon running and more like rearranging your activities to meet your daily step count. The two approaches can work in tandem to produce the best shot at meeting your long-term objectives. 

Why be Tactical?

Asset allocation – which involves dividing your portfolio into different asset categories, like stocks, bonds and cash – is often the biggest factor in determining a portfolio’s returns and volatility. These characteristics are usually based on history, sometimes a very long-term history. In the end, you have a long-term asset allocation that best matches your long-term goals. This allocation is then populated with various investment vehicles including individual securities, pooled funds or Exchange Traded Funds (ETFs) among others.

This approach has worked for investors over the decades, notes Richardson Wealth Chief Investment Officer Craig Basinger, and is something that should remain as the foundation of a properly constructed portfolio, he adds. However, he also believes this prescribed asset allocation is not written in stone and value can be added by tilting around this baseline allocation. Mr. Basinger identifies two key developments that should prompt investors to consider introducing a more tactical approach: Markets have evolved significantly in recent years and expectations for returns moving forward are low.

The rapidly changing face of markets

Over the years, both investors and advisors have been taught that “it's about time in the market that matters, not market timing”. Mr. Basinger certainly doesn’t disagree with this for the core of investor portfolios, but argues that given the nature of markets over the past few decades and with muted return expectations going forward, adding a tactical component can help smooth the path.

Market swings have become larger and more pronounced in recent years, both up and down. This is due to a combination of fund flows, high-frequency trading and more fast money. There was a time a few decades ago, for instance, that the average holding period for a New York Stock Exchange-listed stock was over a decade. Now it is between 2 and 3 years. ETF flows, which measure in the billions, can change from inflows to outflows from one month to the next due to investor appetite. In addition, there are sizable amounts of capital allocated to quantitative strategies that move in and out of the market relatively quickly. This all feeds bigger, faster market swings, the portfolio manager says. That means static asset allocation appears ill-equipped for today’s markets.

“We believe the need to have a tactical component within a diversified portfolio has never been greater,” he says. “The TSX has had a tumultuous ride over the past few years, accelerating in both directions during 2020. Volatility has been similar, albeit slightly less extreme, in the U.S. market, making this a tough investing environment, especially for buy-and-hold investors.”

Winter is coming for the static 60/40

Indeed, while the healthy performance of bonds and equities over the past 30 years has certainly helped reduce the portfolio impact of any missteps along the way, the outlook for the next 5 or 10 years is far more sobering.

Canada’s bond universe, which has contributed a relatively steady 7% annualized performance over the past three decades will be hard pressed to continue this trend, according to the portfolio manager. The yield is currently about 2.5%, which means to maintain a 7% return, price appreciation would need to contribute about 4.5% a year. Since bond prices go up when yields go down, we would just need bond yields to move down enough to lift performance by 4.5% annually. Given the current duration (sensitivity of bond prices to changes in yields) of about 8, we would need yields to fall about 0.5% per year. You can probably imagine where we are going. To maintain a 7% return on bonds for the next five years, we would need yields to drop deep into negative territory for government bonds and maybe even investment grade.

While this may over-simplify the scenario – that is, by ignoring other key elements like credit, changing bond market constituents, convexity, etc. – the conclusion remains: From current levels of bond prices, yields and credit spreads (historically low), it seems unlikely that investors can generate 7% from a broad-based bond allocation during the 2020s, Mr. Basinger says. Let’s assume yields remain flat, as do credit spreads over the next 5 years, a broad-based bond allocation will then generate about 2.5% annually, he explains.

“If bonds are “doing” 2.5%, that means for the 60/40 to maintain its 7.0% annualized nominal return, the 60% in equity has to do a lot heavier lifting. In fact, the equity portion would need to enjoy 10% annualized returns. However, it would imply in 2025 that the TSX reaches 24,350, the S&P 4,960 and the Dow to ring in at 40,000.”

How to be tactical

The key question is how to be tactical, successfully. “It requires a very strong internal fortitude to make calls, often against the consensus or prevailing views, which could just as easily prove wrong,” Mr. Basinger stipulates. “Plus, you need an approach that is repeatable and can be implemented quickly and easily to be effective.”

One approach is to focus on fundamentals, using valuations, sentiment, economic data, or “gut feel” to determine when to tilt above or below baseline equity, Mr. Basinger explains. However, once you have been investing long enough, he adds, “you realize the market makes fools of just about everyone over time. Few investors saw 2008 or 2020 coming for instance. And if they saw the 2020 bear coming, did they see the rebound as well? So instead of trying to “outsmart” the market, which is comprised of many really smart market participants, we opted instead to be faster.”

Using a quantitative rules-based approach

It was amid these prevailing market conditions, characterized by sizeable and fast-moving swings, that Mr. Basinger and his team created in 2011 a quantitative rules-based portfolio called Connected Wealth Tactical (Tactical).

This quantitative strategy can turn defensive quickly if the market loses momentum and heads into a corrective phase or a bear market. It can also participate to a certain extent in any equity market uptrend. Significantly, it can not only make small asset allocation changes of 5% or 10%, but is capable of moving as much as 100% equity or even 100% bonds/cash with no equity.

The objective of Tactical is to provide positive returns in “up” markets, although it is not designed in the first instance to be as strong as the market. In “down” markets, Tactical is designed to be more defensive and protect value, creating a stabilizer for the overall portfolio. Since launching in 2011, there have been a number of market corrections and one big bear market. While each period of market weakness is different, the general pattern has been that Tactical holds onto value during those times, acting as a defensive stabilizer, Mr. Basinger says.

Based on the team’s back-testing and the Tactical Portfolio’s performance since launch, the risk-reduction characteristics effectively kick in during extended periods of market weakness, Mr. Basinger explains. “While it does not catch tops or bottoms, during big swings, either up or down, the Tactical Portfolio tends to be more heavily weighted in the outperforming asset class. We believe this is an effective strategy to incorporate within a portfolio to create a more tactical solution.”

If you would like to learn more about the benefits of a tactical approach or access the document: Connected Wealth Tactical – A Primer, please contact our team.