For the better part of the last 30 years, investing has been relatively easy.  Annualized real returns on U.S. equities have exceeded 8% per year.  These strong equity returns have coincided with a phenomenal bull market in fixed income, allowing investors to have the best of both worlds.  Investing in a 60/40 stock/bond portfolio over this period reduced risk by almost 40% relative to an equity-only portfolio while only giving up approximately 0.5% of real return per year.

Unfortunately, a number of market forces have coalesced since the financial crisis to create a perfect storm that in our view is likely to shipwreck many investors’ retirements without a dramatic change in investing course.

  1. Overall demographic, economic and political trends (longer retirements, diminished access to defined benefit plans, declining savings rates, increased education costs, increased health care costs, etc.) make investors more dependent on strong investment results.
  2. The psychological damage inflicted by the large drawdowns experienced during the financial crisis has increased risk aversion and left many investors underexposed to risky assets.
  3. The most prominent portfolio risk management tool, fixed income, is historically unattractive due to compressed yields.

Over the next month, we will be posting a series of one-pagers that very briefly explain why we believe that tactical solutions can be a valuable tool for investors of all ages.

Part 1 – Millennials

Part 2 – Generation X

Part 3 – Baby Boomers

Part 4 – Retirees

Throughout this series, we will continually refer to Strategy Use AlphaStrategy Use Alpha was described in our recently release white paper, “The Case for Tactical Allocation.”  In the paper, we argue:

"Alpha is a measure of strategy performance on a risk-adjusted basis.  In non-technical terms, the alpha measure seeks to capture the excess return generated by a manager beyond expected compensation for the risk borne.  Traditionally, advisors have sought to substitute alpha-generating managers for passive benchmarks in their strategic policy allocation.

To date, the use of tactical models has followed this standard procedure.  However, since tactical strategies struggle to fit within a traditional benchmarking framework, we believe that using tactical strategies in this manner is sub-optimal.  Unconstrained tactical strategies frequently deviate from benchmarks in a large, meaningful manner, making one-to-one strategy-for-benchmark substitution within a strategic policy allocation near impossible.

Tactical strategies can, however, enable an investor to increase exposure to return generating asset classes. By providing a mechanism whereby a strategy can de- and re-risk, investors may feel comfortable increasing the risk level of their policy portfolio. As a simple example, consider a traditional “60/40” stock/bond portfolio and a tactical strategy that switches between stocks and bonds. With a strategy that has the ability to de-risk, an investor may now be comfortable increasing risk up a 70/30 level, which can have a meaningful impact on total return generated over the investment lifecycle. By holding a 60/30/10  stock/bond/tactical portfolio, the overall allocation has the ability to pivot between a 70/30 stock/bond portfolio to a 60/40 stock/bond portfolio.

This effect can be so powerful that the tactical strategy can actually exhibit negative alpha compared to a traditional benchmark but still add value within the overall portfolio construction. If, in our example above, stocks return 8% a year and the tactical strategy returns 7% a year, then by most definitions the strategy is underperforming its traditional, passive benchmark. However, if bonds are returning 4% a year, by replacing bond exposure with the tactical strategy, we have increased the return profile of the portfolio as a whole. Of course, our willingness to increase our exposure to riskier return generating assets is contingent on our belief that the tactical strategy can effectively de-risk."

We believe the ability of tactical strategies to add Strategy Use Alpha today is greatly increased because many investors have suboptimal strategic policy allocations due to the three factors cited at the beginning of this post.  If tactical strategies can help shepherd investors to making investment decisions that are more appropriate for their individual situation, then the potential for these strategies to add long-term value is significant.

Justin is a Managing Director and Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Justin is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Justin is a frequent speaker on industry panels and is a contributor to ETF Trends.

Prior to Newfound, Justin worked for J.P. Morgan and Deutsche Bank. At J.P. Morgan, he structured and syndicated ABS transactions while also managing risk on a proprietary ABS portfolio. At Deutsche Bank, Justin spent time on the event‐driven, high‐yield debt, and mortgage derivative trading desks.

Justin holds a Master of Science in Computational Finance and a Master of Business Administration from Carnegie Mellon University as a well as a BBA in Mathematics and Finance from the University of Notre Dame.