A properly executed ETF portfolio can ensure steady growth and profitability regardless of the market cycle. Capitalizing on tactical market-moving opportunities can mean the difference between average growth and above-trend results.
Tactical Asset Allocation (TAA) offers investors the opportunity to outperform virtually any market environment. Under this model, asset managers increase a portfolio’s exposure to asset classes that are believed to be more attractive than others. Rather than picking individual stocks or bonds, TAA focuses on broader asset classes to produce more profitable returns or hedge against instability in the market. The goal of this strategy is to take advantage of market inefficiencies by increasing or decreasing exposure to a particular asset class that may be overpriced or underpriced.
The Significance of Tactical Asset Allocation Strategy
This model differs from the strategic allocation approach, in which asset class weights are rebalanced based on fixed rules and risk profiles.
Investors should strongly consider TAA strategies because, as studies show, asset allocation plays a bigger role than security selection in determining overall investment returns. For example, deciding to invest in stocks is a more important decision than choosing one particular stock over others. Studies show that choosing a mix of investment classes can explain 90% of the variability in portfolio returns.
What’s more, markets tend to be less efficient at the asset class level than they are at the individual securities level, which makes TAA an effective source of alpha. That’s because it is more difficult to understand changes at the asset class level versus individual securities. Whereas a quarterly earnings report says a lot about a particular stock, asset classes require a much broader understanding of the fundamental variables that drive the market, such as economic, monetary and fiscal policies, as well as the health of the overall economy.
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How ETFs Can Help in Tactical Allocation
Exchange-traded funds (ETFs) are a welcome addition to any TAA portfolio because they provide cost-effective diversification across multiple asset classes, jurisdictions and investment strategies. Asset allocation ETFs are not only affordable, they provide a systemic approach to TAA that can help investors navigate various market cycles. For example, the iShares MSCI Japan ETF (EWJ ) provides targeted exposure to one major economy, whereas the iShares Russell 2000 ETF (IWM ) provides access to a very specific segment of the U.S. stock market (notably, small caps).
According to the Bank of Montreal, asset allocation ETFs provide at least four opportunities for investors.
- Tactical adjustments: ETFs allow for temporary shifting of underweight or overweight asset classes.
- Cash equalization: ETFs allow investors to maintain a fully invested portfolio.
- Transition and rebalancing: ETFs allow cash to remain invested while switching between asset managers.
- Hedging: ETFs allow investors to reduce their exposure to certain markets without having to sell their underlying holdings.
Learn here about the hidden risks and costs of ETFs.
Risks Associated with the Construction of a TAA Portfolio
In general, there are three considerations investors need to weigh when selecting a TAA portfolio: performance, risk tolerance and time horizon. Naturally, the performance of TAA portfolios varies significantly based on their investment goals. TAA portfolios need to be checked for variance, i.e. how closely they represent the performance of major asset classes.
Like any other investment strategy, an investor must consider their risk tolerance when selecting their TAA portfolio. Some investors use TAA strategies as a single-portfolio solution, while others use TAA as part of a much wider strategy. Understanding what you are willing to risk is an important consideration for TAA portfolios.
Selecting the right time horizon matters because TAA portfolios have multiple extremes. At one extreme, TAAs allow portfolios to function essentially like day traders. At the other end of the spectrum, some TAAs mirror the business-cycle time horizon, which is much longer than the one day traders are accustomed to.
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The Bottom Line
The U.S. bull market may be entering its tenth year, but volatility is showing signs of returning. As markets contend with overvaluation risks, tactical asset allocation is a proven strategy that can help mitigate against potential downside in the near future.