This post is the first in a four part series in which we will discuss why tactical strategies are valuable tools for investors of all ages. Today we will discuss Millennials. Our Millennial one-pager can be downloaded here.
Unlike many tactical managers in the managed ETF space, we do not believe that tactical strategies are one-size fits all. Tactical strategies, like passive index-based products, are just arrows in the investor’s quiver. Whether tactical strategies deserve large or small allocations is very much investor/advisor specific.
In the past, we have often generalized that younger investors should only use tactical strategies as a satellite asset management approach. When you have a 30+ year investment horizon, long-term market exposure is much more important than dynamically adapting to short- to medium-term market movements. This generalization is largely dependent on two assumptions:
- Young investors have age-appropriate asset allocations. In other words, we assume in the first place that young investors are rational when determining their strategic allocation.
- Young investors will stay disciplined during market downturns, resisting the urge to reduce risky exposures.
In simpler terms, if young investors currently have enough risky exposure and have the discipline to maintain or increase risky exposure in the face of market losses, then tactical strategies should only be used in small quantities.
If one or both of these assumptions fail to hold, tactical solutions all of the sudden become significantly more valuable to young investors.
It’s very easy to find both academic and anecdotal evidence that assumption #2 does not hold for the average investor regardless of age. Investors make systematic errors when managing their portfolios.
Recent studies have found that assumption #1 is also faulty for Millennials. Millennials are dramatically underexposed to equities. According to a recent UBS survey, the average Millennial has an equity allocation of 28% compared to a 46% allocation for non-Millennials. This investment positioning is directly related to attitudes on risk. The Investment Company Institute’s 2014 Fact Book reports that 79% of Millennials are not willing to take above-average investment risk.
Many Millennials are wasting a once in a lifetime opportunity: the chance to take advantage of multiple decades of compounding returns.
Tactical solutions can be highly valuable to Millennials if the added psychological security of using a manager that prioritizes risk management allows for asset allocation decisions that are closer to optimal.
In the introductory post to this series, I spoke about evaluating tactical strategies based on their Strategy Use Alpha, which reflects the impact that the tactical strategy has on the risk/return characteristics of the entire portfolio rather than only evaluating the tactical strategy vs. its benchmark. If tactical strategies are used properly, their impact can be so powerful that the tactical strategy can actually exhibit negative alpha vs. a traditional benchmark but still add value within the overall portfolio.
Consider a simple example in which an age 30 Millennial is allocated 25% to stocks and 75% to bonds. In this example, the Millennial would have returned somewhere around 7% in 2013 depending on the specific stock and bond investments1.
Now suppose that the optimal strategic allocation for the Millennial is actually 75% stocks and 25% bonds and that prior to 2013 the investor was introduced to tactical manager XYZ. XYZ offers an equity strategy that has the ability to reduce equity exposure and go to cash in order to protect against large market losses. The Millennial believes in XYZ’s risk management ability and as a result is comfortable with moving 50% of his portfolio from bonds to XYZ’s strategy2.
Depending on XYZ’s decisions, the Millennial’s overall portfolio will now pivot between the current 25% stocks / 75% bonds allocation and the optimal 75% stocks / 25% bonds allocation.
Let’s now return to our 2013 example. Suppose that in 2013 XYZ returned 27%, underperforming its primary benchmark (the S&P 500 represented by the ETF SPY) by ~5%. In traditional manager analysis, 2013 would be viewed as a negative for XYZ due to the underperformance. However, the Millennial would have benefitted immensely overall, returning ~20% instead of the 7% that he would have earned by sitting in the original 25% stock / 75% bond portfolio due to the increased equity allocation.
The moral of story: tactical solutions can be extremely powerful tools for even the youngest of investors if they help these investors make more age-appropriate strategic asset allocation decisions.
1 Uses the return on AGG of -2.0% and the return on SPY of 32.3%
2 In the real world, it probably is not prudent to allocate 50% to a single tactical strategy. When incorporating tactical managers into a portfolio, strategy diversification becomes just as important as asset class diversification.