Tactical Investment Strategies That Bolster Performance
If used correctly, these ETFs can harness momentum and add value to your portfolio.
|A version of this article previously appeared in the August 2022 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.|
Few investors can endure the market's ups and downs for years on end without making changes to their plan. There is a constant stream of information about earnings, inflation, and jobs reports; up-to-the-minute market data and analysis are at anyone’s fingertips. Investors across all levels of experience hear the sirens' call when they perceive an opportunity to beat the market. Many investors tactically maneuver their portfolios in these situations, deviating from their long-term investment strategies to cash in on expected short- or medium-term moves in the market. Others invest in tactical funds that intend to find these opportunities on their behalf.
The benefit of hindsight makes it easy to unearth tactical strategies with market-beating backtests, yet many fail to live up to the hype out-of-sample. There are a few battle-tested tactical strategies available in exchange-traded funds that may play a useful role in portfolios. Sector-rotation and managed-futures strategies have been around for decades and adhere to the same principles as momentum investing in stocks, but they harness momentum in different ways.
Despite investors' penchant for making tactical trades, it's far less common that they invest in tactical funds. Here, I'll dive into each strategy to see whether they deserve a spot in a portfolio and, if so, how best to use them.
Sector-rotation strategies are typically an extension of momentum investing that focuses on sectors instead of individual stocks. Many sector-rotation strategies exist, but the simplest is to invest in the best-performing sectors. I created a sector-rotation model using the Ken French Data Library that incorporates monthly returns for 12 industry portfolios from July 1927 through June 2022.
The model calculated 12-month trailing returns excluding the most recent month, and equal-weighted the three top-performing sectors. Excluding the most recent month's returns bypasses the short-term reversal effect, in which stocks that have performed well during the past month tend to perform poorly the following month. The model rebalances monthly. The results in Exhibit 1 illustrate the strategy's efficacy compared with the broader market.
Momentum strategies take advantage of inefficiencies in human behavior. People are slow to adopt new information and tend to overreact once they make a move. This underpins the phenomenon of investors receiving less-favorable returns than fund returns themselves. With this behavioral advantage in tow, sector-rotation strategies have proved their efficacy over the past century. And the model's outperformance wasn't generated during some long-forgotten market event like the Great Depression. The annualized spread between the model and the portfolio of all industries widened by 23 basis points over the past 20 years, meaning it has maintained its edge for nearly a century.
This sector-rotation strategy also benefits from its flexibility. Unlike a value strategy, for instance, the portfolio is ever-changing, so there is no relative strength to historical norms. There's no material difference in the expected excess return of the model if it loses to the broader equity market for six months straight. The model essentially follows a random walk around the expected long-term excess return versus the market, allowing investors to add or drop the strategy from their portfolio at any time without any pent-up ramifications.
What is not captured by the model are the trading costs of a high-turnover strategy, which come directly out of returns. Sector-rotation funds also tend to charge significantly higher fees than broad equity funds. These costs add a significant drag on performance over the long run. And there's also the risk that investor behavior will change over the long run, eliminating the strategy's edge. Sector-rotation strategies fit best in the equity sleeve of investors' portfolios based on their high correlation to the broader equity market. High correlation to the broader market also means the strategy's ability to quell downside risk is limited. The model only narrowly beat the broader market when stocks were in a drawdown.
Sector-rotation funds are limited in the ETF market. Several launched within the past two years, but only three predated 2020. Exhibit 2 highlights their performance relative to the Morningstar US Market Index since the beginning of 2020.
Tactical-asset-allocation strategies seek to monetize short-term deviations from long-term expectations among asset classes. These strategies may consider macroeconomic data, relative valuations, and technical indicators. They feast on market disequilibrium, meaning they must take on a healthy dose of active risk.
There are tactical-allocation strategies for all types of investors. For example, investors faced a dilemma when inflation began to significantly accelerate in April 2021, yet the Federal Reserve called it "transitory." Aggressive tactical-allocation strategies go all-in on perceived opportunities and may have bought commodities in response to the uptick in inflation risk. Moderate strategies reduce risk and provide opportunity for some gains and may have tactically allocated to Treasury Inflation-Protected Securities. Conservative strategies seek to tactically take risk off the table with capital preservation top of mind and may have rotated into short-term bonds. Finally, contrarian strategies seek out misinterpretation of current risks and look for short-term reversals and may have bought longer-duration bonds in this scenario.
Managed-futures strategies are one of the most prevalent tactical strategies on the market. Investors traditionally accessed these strategies through commodity trading advisors, or CTAs. Myriad proprietary methodologies exist, but they are typically trend-following strategies that go long or short futures contracts across various asset classes, like commodities, equity indexes, currencies, and fixed income.
The long-short portfolio across asset classes results in a very low correlation to stocks. Unlike the sector-rotation strategy, managed-futures strategies are best used to diversify stock exposure and boost risk-adjusted performance over the long run. For that reason, they work best as a replacement for a portion of a traditional 60/40 portfolio's fixed-income sleeve.
Exhibit 3 compares the performance of Vanguard Total Bond Market ETF (BND) and the SG CTA Index, which tracks the daily performance of a pool of CTAs, from the beginning of 2009 through July 2022. BND outperformed the CTA index while exhibiting significantly less volatility, easily crushing CTAs on a risk-adjusted basis.
However, managed-futures strategies have worked very well as a hedge for stocks in recent years. Their uncorrelated returns zigged better than bonds when stocks zagged. This brings added value to portfolios with a moderate to high allocation to stocks. Exhibit 4 compares a 60/40 portfolio, consisting of 60% in Vanguard Total World Stock ETF (VT) and 40% in BND, versus a 60/20/20 portfolio where half of the BND weight is reallocated to the SG CTA Index.
Adding another uncorrelated investment like managed futures improved the 60/40 portfolio despite the SG CTA Index’s awful stand-alone results. This strategy is not without caveats, however. First, managed-futures strategies typically come with high expense ratios, meaning you will likely pay nearly 1% in fees annually, which isn't reflected in the above analysis. Also, "uncorrelated" doesn't mean "negatively correlated." Stocks and managed-futures funds will march to the beat of their own drum, meaning managed futures won't always bail out stocks when things turn south.
Unlike sector-rotation strategies, CTAs' optimal use case is to hedge higher-returning assets like stocks. That means investors will need to withstand a drag on the portfolio when stocks experience an extended rally. Too often, investors ditch their diversifying assets right before they need them most.
Sector-rotation and managed-futures ETFs are relatively small in number and size. New tactical ETFs have launched in recent years, but adoption remains small. There has been an uptick in net flows into managed-futures ETFs after their success in early 2022. And as I demonstrated, there are valid reasons to add these funds to your portfolio. But there is a gap between theory and practice, and the costs do add up with these funds. If used correctly, these funds can harness momentum and add value to your portfolio. For managed-futures strategies, a buy-and-hold approach over the long run is wise.
Bryan Armour does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.