Developing Our Tactical Tools

I had seen the Fortress strategic allocation work during the crisis of 2008. It was far from perfect but it was a heck of a lot better than what most people experienced. It was obvious to me that the job was not done though. Was a passive approach the best we could do? Well, 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?

What does it mean to be passive or active in one’s investing? 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?

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.

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.

So, as I gathered the new team together, our first observation and conclusion was that we already had a strategy – the Fortress Portfolio. And the simplest tactic we could use to implement the strategy was to use index funds (ETFs). It wasn’t a strategy for everyone but it accomplished very well what most investors claimed to want. The average investor isn’t focused on relative performance – beating an index. She’s focused on achieving her financial goals, sending the kids to college and someday retiring. The consistency of the Fortress Portfolio should make those goals easier to plan for and achieve. And the relatively high returns and low volatility should make them achievable using reasonable assumptions.

Our business plan was – still is – to serve the vast middle who aren’t so rich they’ve got people knocking down their door offering good advice. We think it is a big market not being served well. We also think it is where good advice is most needed. These were the people burned by Wall Street in 2000 and 2008. Our goal all along has been to help those people get good advice at a reasonable cost.

And the reason most investors were burned in those two bear markets was due to the lack of a good strategy. Or more likely, no strategy at all. If you examine investor brokerage statements – as we do regularly for potential clients – most investor portfolios are constructed haphazardly. They have a collection of investments that represent tactics but without the context of a strategic plan. Investors and their advisers concentrate intently on the trees but completely ignore the forest.

Choosing the right fund, actively managed versus index, matters but it pales in comparison to getting your asset allocation, your strategic plan, right. Keeping fees low is important but developing a proper strategic plan and making sure you stick to it is a valuable service. There is ample – more than ample – academic research to back up that assertion. Asset allocation, your strategic plan, is, by far, the most important part of your investing plan and has the greatest impact on your portfolio return.

A strategic plan must allow the investor to meet his goals in a way that is compatible with his risk tolerance. If you were not able to maintain your equity allocation through the 2008 crisis, if you sold near the bottom and couldn’t get back in, your problem was not tactical. You didn’t sell because you had an actively managed mutual fund instead of an index fund. You sold because your allocation to stocks was too large, a strategic error. The Fortress Portfolio is a strategic plan that allows you to ride out the worst case scenario.

So, we had our strategy – the Fortress Portfolio. Our next task was to determine if there were tactics we could employ that would improve the performance.

Our second major observation and conclusion was that changes to the asset allocation had to be rare and temporary. Why? Because the asset allocation is the strategic plan and as such must be fairly rigid. There had to be a very good reason for altering the asset allocation. What could be so important that it caused us to deviate from our strategic plan?

After a lot of research and a lot of debate, we settled on five triggers that are significant enough to deviate temporarily from the strategic plan:

Yield Curve – the difference between long and short-term rates is the most accurate predictor of recession and recovery

Credit Spreads – the difference between junk bonds and Treasuries is another good indicator for recession

Valuation – valuation provides a good estimate of future returns and therefore risk

Momentum – momentum exists in markets because humans trade on emotion

US Dollar – the movement of the dollar can have a dramatic impact on various asset classes

We use these indicators to shift among the risk-adjusted Fortress Portfolio allocations. If the yield curve and credit spreads indicate that recession is imminent we can shift from the Moderate Risk Fortress to the Moderately Conservative Fortress. If valuations are low we can shift from the Moderate Risk Fortress to the Moderately Aggressive Fortress.

The trend of the dollar is used primarily to determine the split between domestic and international assets. In general, one wants to own non-US assets when the dollar is falling in value relative to other currencies and avoid them when the dollar is rising.

Momentum is used in our Pathfinder Portfolio to rotate among the various asset classes in the portfolio based solely on momentum. We believe that it is markets that shape the economy, not the economy that shapes the markets. What that means is that market movements are not anticipatory but rather drivers of economic change. It isn’t that investors sell off junk bonds, thereby widening credit spreads and predicting recession. It is that investors sell off junk bonds, thereby widening credit spreads and causing recession. Momentum is a way to position the portfolio in advance of economic changes.

We had now identified several tactics we could use to alter the asset allocation. The next step was to identify tactics for altering the individual asset classes themselves. We identified several techniques for doing so:

  • Substituting actively managed funds for the index funds in the original Fortress Portfolios.
  • Substituting individual securities for funds. An individual REIT instead of a DJ REIT index ETF.
  • Momentum within the asset class. Momentum might favor a sector fund over the S&P 500 or emerging market stocks over developed market stocks or a country fund over a more diversified fund.

The final tactical changes we can make are based on fundamental factors, substituting individual stocks for funds. Our three individual stock portfolios:

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

The first was developed by the Alhambra team while the last two were derived from research done by Margie Fernandez before she came to Alhambra. For portfolios of a suitable size, we can substitute one of these individual stock portfolios for some portion of the equity allocation.

When we combine all 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