Using ETFs in Tactical Asset Allocation Strategies

Synopsis:

Stocks and bonds are the fundamental building blocks of any investment portfolio. The
types of stocks and bonds on which you choose to focus your portfolio will
indelibly stamp your future investment performance. The blueprint for this
focus is called the master asset allocation plan, and many argue that it
represents the single most important decision that can be taken in an
investment program. A well-constructed portfolio carries out the objectives of
the investor by adhering to its preordained allocation formula. However, many
portfolio managers have found they may enhance performance by adapting their
allocation formula as the market environment changes, a practice often called
tactical asset allocation. Exchange-traded funds (ETFs) can be a powerful tool
for building and maintaining a portfolio that rigorously meets investment
objectives while at the same time flexibly adapting to the changing dynamics of
the market. This article discusses the use of ETFs when implementing a tactical
asset allocation strategy.

Key Points

Exchange-traded funds (ETFs) may be ideal tools for helping
savvy investors execute a tactical asset allocation strategy. A general
understanding of tactical asset allocation can help crystallize this strategic
use of ETFs.

The process of creating an allocation starts with an
assessment of the investor’s age, goals, and risk tolerance. Because these
factors are fixed, many assume that the resulting allocation plan must be
static. However, every asset class has its own unique market cycles and economic
influences. An investor can often identify these individual patterns and use
that insight to guide his or her investment processes — shifting value to an
investment that might outperform the average from an asset type showing
potential to lag behind broad market performance. ETFs can provide a high
degree of precision in targeting the exact proportions needed for an effective
tactical execution.

It is important to emphasize here that tactical asset
allocation is not the same thing as market timing. Tactical allocation
adjustments are a form of fine-tuning for an established long-term master plan,
often done in response to broader market trends. Such measured alterations to
the core blueprint may be left in place for weeks, months or even years as environmental
conditions warrant. Market timing, on the other hand, is more like betting —
its success depends on profitably gauging the size and scope of random market
spikes while avoiding the equally prevalent random market troughs.

Exploitable Financial and Economic Cycles

Tactical asset allocation is active asset reallocation — that
is, changing your investment mix in response to actual environmental changes as
markets rise and fall and the economy strengthens and weakens. For example,
stocks and bonds each have their own bull-market and bear-market cycles. As a
consequence, there will be times when stocks are overvalued relative to bonds,
and vice-versa. Furthermore, there will be times within each asset class’s
market cycle when some identifiable subset of those assets moves out of line
from the overall average. The asset of opportunity may be a particular class of
bonds, or the stocks of companies in a specific economic sector. Niche-focused
ETFs can be used to increase your investment exposure to just those asset
categories that might be needed to implement your short-term strategy.

Market Dimensions That Can Be Exploited by ETFs

Growth and Value

The relative performance of growth stocks and value stocks
historically has been dependent on the market cycle. Growth stocks often have
made their greatest gains in the early stages of a bull market, while value
stocks have produced stronger appreciation as a bull market ages. In fact,
during three of the past four times since 1978 that a bull market has entered its
third year, the value component of the S&P 500 outpaced the growth
component on both a percentage change and frequency of out-performance basis.
ETFs that are composed purely of growth or value stocks can be used to add
weight to one style or the other selectively.1

Earnings and Market Cycles

Bull markets are traditionally marked by rising stock prices
and increasing stock valuations. In fact, valuation — the amount of money that
an investor is willing to pay for a dollar of expected earnings — is often a
closely watched indicator of a potential turn in the direction of the market.
Valuation is measured by a statistic known as the price-to-earnings ratio
(P/E). As seen in the chart that follows, the level of P/E in the market is
often associated with a change in direction. This often indicates the extent to
which stocks might become overvalued or undervalued. (It should be noted that
P/Es tend to be higher today than they were 50 years ago, so the levels of the
next peaks and troughs might be expected to be higher than the simple averages
might otherwise predict.)

Investors concluding that stocks have become overvalued may
seek to reduce the proportion of equities in their portfolio by increasing the
percentage of assets committed to bonds; when stocks are undervalued, they seek
the reverse. ETFs that mirror the broad equity and bond market allow an
investor to shift this emphasis quickly and efficiently.

P/E
Ratios of the S&P 500 During Bull Markets
Start
of up cycle
End
of up cycle
P/E
at start of cycle
P/E
at end of cycle
Increase
in P/E on S&P 500
Rise
in price of S&P 500
04/29/1942 05/29/1946 7.2 21.4 197% 153%
06/14/1949 08/02/1956 5.7 13.8 142% 264%
10/23/1957 12/12/1961 11.2 23.8 113% 86%
06/27/1962 02/09/1966 15.5 18.1 17% 80%
10/10/1966 11/29/1968 13.3 19.1 44% 48%
05/27/1970 01/11/1973 12.6 18.7 48% 74%
10/04/1974 11/28/1980 6.8 9.6 41% 126%
08/13/1982 08/25/1987 7.2 23.4 225% 229%
12/07/1987 07/16/1990 14.1 17.4 23% 65%
10/12/1990 03/24/2000 13.6 31.7 133% 417%
10/10/2002 10/09/2007 25.9 19.9 -23% 101%
03/09/2010 Ongoing 98.6 NA NA 85.9%*
Source: Standard & Poor’s. The S&P 500 is an
unmanaged index of stocks considered to be representative of the
large-capitalization U.S. stock market. For the period January 1, 1940, to
December 31, 2011. Investors cannot invest directly in an index. Past
performance does not guarantee future results.
*Increase in price through December 31, 2011.

The Potential Value of Sector Rotation

Economists divide the economy into broad sectors — groups of
similar industries that tend to demonstrate similar business dynamics. Some of
these sectors have demonstrated distinctive patterns of performance during the
year. An investor who added the right sector ETF could have enhanced returns
proportionately. For example, during the 15-year period from January 1997 to
December 2011, Consumer Staples and Health Care have generally performed
stronger in the warmer months of each year, on average, and trailed in the
cooler periods (a pattern opposite most other sectors). An investor who
disproportionately increased either of those sectors in his or her portfolio
may have had the opportunity to boost returns accordingly.2

P/E
Ratios of the S&P 500 During Bear Markets
Start
of down cycle
End
of down cycle
Decline
in P/E on S&P 500
Fall
in price of S&P 500
05/29/1946 06/14/1949 -73% -29%
08/02/1956 10/23/1957 -19% -21%
12/12/1961 06/27/1962 -35% -28%
02/09/1966 10/10/1966 -27% -22%
11/29/1968 05/27/1970 -34% -36%
01/11/1973 10/04/1974 -64% -48%
11/28/1980 08/13/1982 -25% -27%
08/25/1987 12/07/1987 -40% -34%
07/16/1990 10/12/1990 -22% -20%
03/24/2000 10/10/2002 -18% -49%
10/09/2007 3/09/2009 -22% -57%
Source: Standard & Poor’s. The S&P 500 is an
unmanaged index of stocks considered to be representative of the large-capitalization
U.S. stock market. For the period January 1, 1940, to December 31, 2011.
Investors cannot invest directly in an index. Past performance does not
guarantee future results.

Other Considerations for Tactical Allocation

For as many different ways that investment can be categorized,
there are opportunities for fine-tuning an allocation to take advantage of
divergences in performance cycles. Large-cap stocks and small-cap stocks each
have unique market cycles. So do each individual country and geographic region
of the world. Keep in mind that the statistics for measuring these cycles might
be imprecise, adding uncertainty to any active reallocation program.

Successful implementation of a tactical allocation plan may
require more attention to maintenance than a static portfolio. Turnover —
selling one asset while simultaneously buying another — tends to be costly.
Commissions and fees can be considerable, and a reallocation transaction can
create a capital gains tax liability. To minimize turnover (and its attendant
costs) many investors try to change their asset mixes only when they add assets
to their portfolios or when forced to sell a holding for some other reason.
Because each ETF is clearly focused on one asset class or style, it can be well
suited for executing changes in allocation policy.

Points to Remember

  1. Tactical asset allocation is the practice of adjusting portfolio allocation to meet
    changing market conditions or exploit market cycles. It is not an attempt to
    time the market by betting on short-term volatility.
  2. Exchange-traded funds (ETFs) allow an investor to realign allocation by adding precisely the
    asset class, style, and amount needed to achieve any desired effect.
  3. Tactical asset allocation can involve changes in the mix between stocks and bonds, or
    changes in the mix of types of stocks and bonds.
  4. Some forms of reallocation are tied to economic changes, some to stock market cycles
    and some to interest rate changes.
  5. Turnover can be costly, therefore many investors try to change the asset mix within
    their portfolio only when they add assets or when forced to make a change for
    tactical reasons.

Source/Disclaimer:

1Source: Standard & Poor’s. The S&P 500 is
an unmanaged index of stocks considered to be representative of the
large-capitalization U.S. stock market. Investors cannot invest directly in any
index. Past performance does not guarantee future results.

2Source: Standard & Poor’s. The S&P 500 is an unmanaged
index considered representative of large-capitalization U.S. stocks. For the
period January 1, 1997, to December 31, 2011. Investors cannot invest directly
in any index. Past performance does not guarantee future results.

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© 2012 McGraw-Hill Financial Communications. All rights
reserved.

March 2012 — This column is provided through the Financial
Planning Association, the membership organization for the financial planning
community, and is brought to you by Ronald J VanSurksum, CFP® , a local member
of FPA.

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