Although traditional portfolio management theory holds that investing in a variety of asset classes provides sufficient diversification, in recent years correlation has increased to the extent that investment mandates increasingly call for more nimble allocations.

“I’ve always had a belief that as markets change, investment portfolios should adapt to what is going on in the financial markets,” said Michael Ball, portfolio manager at Weatherstone Capital Management, a Denver-based company with $785 million under management. “Virtually any investment can have times where it could do well, and times where it could do poorly. By default, we’ve been tactically managing money all along the way.”

Tactical asset allocation programs are designed to protect against severe portfolio losses through intermediate-term asset allocations, as distinguished from strategic asset allocation programs, which maintain full exposure throughout market cycles in anticipation of long-term market returns.

In the case of baby boomers, the pendulum has swung from strategic to tactical investing as they start drawing down their savings. “People are transitioning from building their retirement nest egg to starting to living off of that retirement nest egg,” Ball said. “In that transition, the role of managing volatility becomes increasingly important.”

For example, a person who draws 25% out of their retirement savings while still employed can expect to recoup that draw-down with an annual return of 9% over three years, but if the same person draws the 25% out after they’ve retired, they would have to earn a 19% percent return over three years. “The odds of making 19% for three consecutive years are pretty low,” Ball said. “What can happen is you can get a portfolio into a downward spiral that it may never recover from.”

Several trends are driving momentum behind the multi-asset-class movement, according to Cerulli Associates. Both institutional and retail investors are searching for diversified sources of alpha or income; managers are competing against passive investments in single highly liquid asset classes; and there is a greater focus on specific objectives such as risk-factor targeting, risk mitigation, inflation protection, or targeted income levels.

Weatherstone Capital’s 12 investment professionals spend a good deal of time filtering data to quantify how the risk profiles for different asset classes stack up, and allocate assets accordingly.

“We strive to quantify what the risk is as we see items that may indicate that we may have higher risk in different asset classes, and look to adjust how much we’re allocating there,” Ball said. “We have the flexibility to go fully to cash if we need to. The goal is over a full market cycle to do well, and to do so with a minimal level of volatility.”

The process is top-down beginning with macro factors: How are markets moving compared to past markets? Are there headwinds or tailwinds from interest rates? Are market advances or declines broad-based or fairly narrow?

This is followed by an analysis of how different sectors and asset classes are likely to perform given overall market conditions.

“It’s something that’s certainly more work intensive then saying ‘This is a good long term value. We’ll let it play out over five or ten years’,” Ball said. “Much of what we’re doing is either weekly or monthly updates to models, some of them are daily updates. We’re prepared to move money at any time during that process as things change. We’re not the type of a manager where the world’s either black or white. We typically start to move in stages as things become progressively more or less attractive.”

Featured image by Eisenhans/Dollar Photo Club