As fiduciary financial planning and passive asset management eclipsed old-fashioned stock selection, a growing number of financial advisors have turned to asset allocation based on the efficient market assumption.
This assumption is based on the idea that stock prices reflect all publicly available information and that it is impossible to consistently and persistently generate a return above the broader market.
But does rising stock market volatility combined with bond yields underperforming relative to their historical performance mean it’s time to take a more tactical approach? Tactical investing is an active portfolio management strategy that changes the percentage of asset class categories to capture current market strength or mispricing.
That contrasts with the efficient market hypothesis, which states that it is impossible to outperform the market systemically, since mispricing does not persist.
“The last year has shown that passive asset allocation is not immune to market downturns,” says Andrew Pesco, director of investment management at Domain Money in New York.
He notes that the classic 60/40 portfolio, represented by the Bloomberg 60/40 index, is now down more than 12% from its peak on December 27, 2021.
“To put that in context, the 60/40 portfolio has had an average return of 5% over the last 100 years, so this drawdown has erased over 2 years of average return,” says Pesco. “These withdrawals provide opportunities for selective investors to deploy capital into investments in both tech stocks and crypto.”
Other advisers and asset managers agree that current conditions are not optimal for building traditional strategic portfolios.
“We believe that a tactical allocation serves clients better than a strategic allocation,” says Loreen Gilbert, founder and CEO of WealthWise Financial Services in Irvine, California.
“Right now, it’s a stock picker market and not an index market. Tactical allocations can do better for clients if the tactical moves are right,” he says.
Decrease in portfolio risk
Since the beginning of the year, Gilbert has decreased the international exposure and duration of fixed income in client accounts. Meanwhile, she pushed the weighting of value stocks as well as hedged positions, cash and commodities. Those moves also served to lower the portfolio’s beta, or measure of its overall systematic risk.
While portfolios with a static allocation to investment-grade bonds have seen significant losses due to rising rates, more dynamic portfolios can reduce exposure to those bonds in favor of other instruments that appreciate more with inflation, he says. Nadia Papagiannis, Senior Vice President of Multinationals. asset class solutions at Northern Trust in Chicago. These include inflation-protected Treasury securities and high-yield bonds that have less sensitivity to interest rates.
Papagiannis adds that Northern Trust Asset Management also repositioned the equity side of client portfolios during this volatile and inflationary period by overweighting US companies, which are less affected by the Russia-Ukraine war than international stocks. The company has also overweight the portfolio in natural resource stocks, which have historically protected against inflation better than other asset classes and are a source of high income right now.
“While growth stocks performed well in 2019 and 2020, investors still exposed to them through static portfolios are hurt by their significant underperformance versus the broader stock market,” says Papagiannis. That’s because of rising rates and inflation, which favor stocks that generate value and dividends. Tactical Portfolios were able to make appropriate adjustments to changing conditions.
That is not to say that all tactical approaches are suitable for today’s market. For example, Papagiannis points out that simply trading ETFs across different sectors of the US stock market can only serve to increase transaction costs and tax liabilities for investors, without adding significant portfolio value with time.
“Factor-based investing, or looking for stocks with quality value and dividend characteristics, is more effective, according to our research,” he says. “We are also not in favor of drastically changing the risk profile of a portfolio. An example of this is reducing risk by putting in cash, which could result in market discomfort and missed recoveries.”
Of course, even in a recession, it can literally be worth pursuing investments with the potential to rise once the trend reverses.
Opportunity in a recession
“In the equity market, we see significant opportunities to deploy capital to companies creating must-have technology with large addressable markets, excellent leadership teams, and continuing to generate growth and capital at high rates, even over the recent period,” says Pesco. “Many of these companies are trading 30% to 70% below their all-time highs and are trading at the lowest valuation multiple in years.”
Pesco, whose company specializes in crypto investing, says research from Domain Money shows that investors should consider allocating 0.75% to 6% of their liquid portfolio in a basket of cryptocurrencies. He says the specific amount would depend on an investor’s time horizon and risk tolerance.
“Given the recent drop in cryptocurrency prices, we believe the current environment is particularly favorable for making a long-term allocation,” he says.
However, he does have a caveat for those who want to implement a tactical approach.
“Our philosophy is that investors should not over-trade their portfolios. Drawdowns, especially of the magnitude of recent market moves, are hard to stomach, but staying invested is a key determinant of long-term investment success.” , He says.
Pesco adds that investors should expect long-lived assets such as technology stocks to show greater volatility in times of uncertainty.
“That said, we actively monitor our existing investments and are constantly looking for attractive entry levels to buy companies and cryptocurrencies that will be the leaders of tomorrow,” he says.