Most advisors have heard of tactical investment management. But there are so many possible angles a tactical manager can take, the options all blend together after a while.
Buy-and-hold investing is likely to morph into buy-and-hope investing, given today's historically high stock valuations and historically low bond yields. So this is an excellent time for advisors to look for complementary pieces to the portfolio puzzle and deploy tactical investing methods.
Let's start with the main reason to consider tactical investing: the realities of today's stock and bond markets. They function very differently than they did in the past. Changes include more types of participants, algorithmic trading, lightning-fast dissemination of information and commission-free trades. Throw in the possibility that the most popular stock market indexes have "pulled forward" years of gains, thanks to Federal Reserve intervention, and you get perhaps the best environment for tactical management that advisors have seen in a long time.
Veteran financial advisors were taught to buy stocks and bonds, allocate according to client risk tolerance and time horizon, and keep trading turnover to a minimum. That is referred to as owning investments. But just as the real estate market offers opportunities to own a home or rent one, so it is with stock and bond markets.
The enormous growth of exchange-traded funds, for example, has allowed tactical managers a choice: They can rent individual stocks, or they can rent swaths of the stock, bond, commodity and currency markets through a single ETF trade. That is, they can buy something based on their belief that it will rise in price, but that rise will be short-lived, lasting months or even weeks. The more choppy the market is, the more likely that well-devised tactical strategies can prosper.
And although there was a time when higher trading frequency was considered a bad thing, tactical managers are now being recognized for their ability to stem losses during major market declines. So with all due respect to Olivia Newton-John, "let's get tactical" with the following five investing methods that financial advisors can use for client portfolios:
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Sector rotation is probably the most common approach used in tactical investing, though that is changing. This method capitalizes on the concept that the stock market is really a collection of different economic areas or themes. There are 11 major sectors of the S&P 500, and each of those sectors has subsectors, or industries. These subsectors often do not move in sync. That creates opportunities to own the stronger ones and avoid the weaker performers.
Sector rotation can also be divided into the types of sectors or market segments you wish to consider renting. For some, sticking to the S&P 500 sectors adds a layer of familiarity. But for others, the tactical universe might also include more volatile, growth-oriented industries that tend not to move in step with the more familiar sectors.
The same idea can be used with different types of stocks, such as growth and value; large-cap, mid-cap and small-cap; and U.S. and foreign stocks. In recent years, the concept of factor investing has gained popularity, and some tactical managers have found value in rotating among investments such as high-dividend stocks, stocks with a low price-earnings ratio and low-volatility stocks. The ETF business has actively brought factor products to market, which makes this type of tactical management much more fluid than in years past.
In a market climate starved for reliable income yield, tactical strategies may be able to lend a hand. This is probably the most precise area of the tactical world, which is probably why it is not as popular as rotation strategies. However, there is potential to make a high yield from stocks or bonds by holding them long enough to earn dividends while avoiding the biggest price dips. This is not the same as dividend capture, which involves buying a stock on the last day you're eligible to earn a dividend, then selling it the day after.
In tactical income investing, the manager should be aware of the rules surrounding qualifying dividends. Stocks need to be held for a specific number of days on either side of the dividend ex-date to be taxed as dividends rather than at higher earned income rates. A financial advisor should not just go out and do this without a lot of strategic planning first.
Advisors who understand the value of hedging as a tool for reducing the impact of major pullbacks and bear markets will appreciate that hedging is essentially a tactical strategy.
Hedging continuously over many years can damage a portfolio's returns. So successful tactical hedging hinges on two factors: the amount you hedge at a particular time and the hedging vehicles you choose.
At its most basic level, arbitrage involves buying a security and shorting another security that you think will perform similarly. That results in your return being the difference between the two securities, your "long" and your "short."
Today's vibrant markets allow a wide range of strategies that aim to keep volatility low and seek modest positive returns. While this type of strategy is clearly not the same as investing in cash equivalents or short-term bonds, if done successfully, it may be a way to get clients off the sidelines and invested with relatively low risk. For example, a growing number of ETFs can represent the short side of a tactical arbitrage system. That is good news for advisors amid the low returns on bonds and cash.
Tactical investing is only worth the effort if you, the advisor, are willing to put the work into understanding how it can help, and what it does and doesn't do. Some tactical investors are out to make enormous returns, and therefore, they accept enormous risks. An example is when tactical traders use leveraged index ETFs. But the tactical methods recommended here are most likely to benefit financial advisors with clients who don't think they can afford to hold and hope as they near or continue in retirement.
Investors are not as patient as they used to be. Furthermore, they have been spoiled by markets that fall hard but get up just as fast. That is not as likely to happen going forward. And when it does, you risk having their eyes glaze over while you tell them to hang in there and that corrections are healthy. Adding some form of tactical approach to your investment arsenal makes sense if you put risk management first and adding to long-term returns second. Tactical methods give you the ability to pivot when the markets suddenly drop or buy in to solid investments on a dip.
To sum it up, tactical investing means adding flexibility. Whether you choose to develop your own tactical investing strategy or adopt someone else's approach, you are adding value to your practice and client communication just by weighing the options. You don't want to be the one left holding the proverbial bag as investor preferences evolve along with changing markets.