So, now my client was happy with the portfolio I’d built for him. It met his criteria and the market had provided ETFs to implement the portfolio. But it didn’t feel like the job was done. Was this the best we could do? A passive portfolio that, once built required little thought or attention? If you ask the proponents of passive investing the answer to that question is a resounding yes.

The public appears to agree. According to Morningstar, in 2016 US index funds received inflows of $492 billion while their active counterparts saw outflows of $204 billion. Passive has won the debate, John Bogle’s legacy is assured.

Or has it?

I have often heard passive and active equated with strategic and tactical respectively. But no one ever really explains what they mean by that. Coming from a military background I didn’t think the terms fit that well. What is a strategy? What is a tactic? Are the two interchangeable?

A Strategy, according to the Oxford English Dictionary, is:

  • A plan of action designed to achieve a long-term or overall aim.

To get a little more specific for our purposes, Strategic is:

  • Relating to the identification of long-term or overall aims and interests and the means of achieving them.

A Tactic is:

  • An action carefully planned to achieve a specific end.

And Tactical is:

  • Relating to or constituting actions carefully planned to gain a specific (military) end.

So, tactics are methods used to achieve shorter-term goals that help one accomplish an overall strategy. Strategy is fairly rigid while tactics must be flexible and fit the situation. Strategy guides the entire endeavor while tactics concentrate on specific parts of the strategy. 

The Fortress Portfolio was obviously a strategy. The tactic employed was the use of index ETFs to implement the strategy. The strategy concentrates on the big picture while the tactics are about the details of implementing the strategy. The strategic plan lays out an asset allocation, the different asset classes to include. The tactical plan might look for ways to improve the performance of each asset class.

So we had our strategy – the Fortress Portfolio – and were happy with the results. Given our goals – maximize returns and minimize drawdowns – this was the best strategic plan we could manufacture. Improvement would have to come from the tactical side. The obvious question was how?

And the most obvious answer was to find investment vehicles representing the various asset classes in the Fortress that outperformed the index ETFs. Anyone who’s been an investor for any length of time knows that is not an easy task. In fact, the vast majority of actively managed funds underperform their benchmark index. And there is turnover in the funds that do outperform in any given year. A fund that beat the index over the last five years is no more likely to outperform over the next five years than the average fund.

Furthermore, even if you could find funds that outperformed consistently the payoff to the entire portfolio is fairly small. If you could find a large cap fund that outperformed the S&P 500 by 1%/year after fees – not easy to do – it would only change the return of the overall moderate portfolio by 23 basis points (0.23%). For asset classes with smaller allocations, the reward is even smaller.

What does pay off are changes to asset allocation. If you correctly change the allocation to a specific asset class the reward can be large. Over the last 10 years, the difference between a 25% allocation to the S&P 500 and a 40% allocation is almost 200 basis points annually (2%). So it seemed obvious that if I was to improve the performance of the Fortress Portfolio the first avenue to explore was how to temporarily alter the asset allocation of the strategic plan.

After much research, I reduced the triggers for asset allocation changes to just five:

  1. Yield Curve – the difference between long and short-term rates is the most accurate predictor of recession and recovery
  2. Credit Spreads – the difference between junk bonds and Treasuries is another good indicator for recession
  3. Valuation – valuation provides a good estimate of future returns and therefore risk
  4. Momentum – momentum exists in markets because humans trade on emotion
  5. US Dollar – the movement of the dollar can have a dramatic impact on various asset classes

We consider these factors first to determine whether a temporary deviation from the Fortress Portfolio strategic asset allocation is warranted. If the yield curve and credit spreads indicate recession is imminent, we can shift to a more conservative Fortress Allocation. If valuation indicates low future returns we can shift to a more conservative allocation. If the dollar is in a downtrend, we can shift from domestic assets to non-US assets.

Once asset allocation changes are made, we then can consider any other changes we can make to each asset class to improve performance. These changes are of two types – fundamental and momentum. Momentum tactics are captured in our Pathfinder Portfolios:

  • Momentum Allocation – rotation among various asset classes based on recent returns
  • Sector/Industry Rotation – rotate among sector or industry ETFs based on recent performance

Fundamental tactics are captured in our individual stock portfolios:

  • Value, Quality & Momentum
  • Dividend Growth
  • Earnings Revision

When we combine these tactical changes we get what we call the Alhambra Portfolios. These portfolios start with the same allocation as the Fortress and are then changed based on the above factors. An Alhambra Portfolio might be changed from the Fortress as follows:

  • Valuation is expensive and the allocation is shifted to a more conservative one. A moderate investor would shift from the 40% bond version to the 50% bond version.
  • The dollar is in a short-term downtrend so non-US assets are introduced into the portfolio.
  • The VQM individual stock portfolio is used in place of a portion of the large cap stock allocation.
  • A portion of the portfolio is invested in the Momentum Allocation Pathfinder portfolio.

Our original moderate Fortress Allocation looked like this:

Our tactically-adjusted Alhambra Portfolio might look like this:

It still has the same elements as the original Fortress – Large cap stocks, small cap stocks, real estate, commodities, and bonds – but the allocation has changed as well as the composition of each asset class. Instead of just the S&P 500, the portfolio also now owns the stocks in the VQM portfolio. Part of the portfolio is invested strictly according to momentum – the Pathfinder Portfolio. And international stocks, real estate, and bonds have been substituted for their US counterparts.

The tactical changes we make to our Fortress Portfolio are ones that are well researched, not just by us but in the academic arena. The momentum effect is well-known and persistent. Value, quality, and earnings momentum are well-understood factors that have been shown to produce superior stock portfolios. Concentrated portfolios – all our portfolios have 25 stocks or less – are known to be a common factor among successful mutual funds. The yield curve is – by far – the most accurate predictor of recession known. Credit spreads are highly correlated with the business cycle (recession and recovery) and stock market returns.

The Alhambra Portfolios are the culmination of years of research. The combination of a proper strategic plan – the Fortress Portfolio – and intelligent tactics produce a superior portfolio – the Alhambra. 

Joe Calhoun, CEO