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Investment Strategies: Two Flavors

Portfolio management consists of three main elements: investing time horizon, diversification of investments, and risk tolerance. Investing, then, requires saving money to invest (perhaps the hardest part for some), and then developing a diversified portfolio (which may need to be adjusted periodically based on life changes). The focus should always remain on the investor’s maximum time horizon, and the strategy chosen should conform to the investor’s risk tolerance.

It may seem that there are more investment strategies out there than there are investors. Truth is, strategies only come in two basic flavors—active and passive.

Passive management involves attempting to conform to a benchmark by replicating its holdings, and hopefully, its performance. Passive portfolios have a long-term focus, typified by buy-and-hold investing. Also known as " Prudent Man” investing, do-it-yourself diversified passive portfolios are comprised of several non-correlated equity and income assets. The percent allocated to each asset class in the portfolio is determined by the investor’s willingness and ability to accept risk. Stocks are riskier than bonds and cash, so the higher the percentage of stocks in a portfolio, the riskier it is. The more risk, the greater the opportunity for gain-- or loss. Generally, an aggressive growth portfolio is 80% stocks, a growth portfolio is 60% stocks, a conservative growth portfolio is 40% stocks, and an income portfolio is 20% stocks (mostly dividend producing.) In general, passive strategies require less time, effort, cost, and expertise than active strategies. Moreover, there are now smart exchange traded funds that passively manage a particular asset allocation strategy for you. Passive investing is best employed when the time horizon is greater than 5 to 8 years, however.

Active strategies involve actively selecting investments in an effort to outperform some benchmark, usually a market index. They have a short to medium term “market-timing” focus and are typified by more frequent trading. Active strategies are the opposite of passive diversification. They can take many forms, including the do-it-yourself market timing methodology promoted on this site for over twenty years as well as new smart exchange traded funds that actively manage a particular strategy for you. Purely active strategies are more appropriate for investors at the aggressive end of the risk spectrum.

So Which Strategy Is Right For You, Active or Passive? 

I’ve been a proponent of an active market-timing strategy for almost twenty-six years. Index Moose was my first attempt at modeling the markets using momentum, and it worked well for 16 years, returning close to 30% a year. In 2009, however, the Fed began a decade of financial engineering, government fiscal policy thereafter turned deflationary, and GDP growth stagnated. Without a tangible business cycle, bear markets, and just the occasional correction, the model began to have a hard time keeping up with its benchmark. This led me to the inevitable realization that no portfolio management strategy is perfect for every place, time, and person— not active market timing, not passive buy-and-hold, and not any variant of the two. In short, when the financial environment and/or one’s personal circumstances change, strategic approach must change.

That was not always as obvious as it sounds. Back in the day, we were told to pick a strategy—active or passive-- and stick with it for life. You didn’t deviate, because human nature being what it is, we all tend to deviate at just the wrong time. Moreover, before personal computers, managing a portfolio manually could be time-consuming enough without trying to master multiple strategies to boot. Most portfolios were managed using a diversified buy-and-hold approach, the so-called “prudent man theory”. Mutual funds, the primary financial instrument used, were designed for buy-and-hold, and penalized frequent trading.

Meanwhile, strategic choices were portrayed in black and white. You had to pick sides. Books were written and verbal fistfights ensued over who was right: gambling market-timers or prudent random-walkers. It never dawned on anyone that both active and passive approaches might be valid, or even a mix— at different times in different situations.

Fast-forward a quarter century and times have changed. Everyone has a laptop, access to the Internet, and can trade online. The brokerage fee for buying 100 shares of stock is no longer $300, but closer to $8. Exchange traded funds allow investors to diversify and trade that diversification intraday. Most importantly, technology has opened up the financial world to an explosion of new ideas and products, greatly simplifying the portfolio management process.

Strategies are Personal

Before picking any investment strategy you need to ask yourself  (1) Am I totally committed to managing my own money? (2) Am I capable of managing my own money? If the answer to either question is "no", hire someone to do it for you. (In my experience, you can cut yourself some slack on #2 as long as the answer to #1 is a firm “yes”. When you dedicate yourself to something fully, you’ll be amazed at how quickly you become capable.)

If the answer to both questions is "yes", start by realizing that over time, there is not necessarily a 'best" investment strategy for everyone all the time. A strategy’s success or failure depends on the financial back-drop. Just because you find something that appears to work for you now, doesn't mean it always will. Personal situations change, and exogenous conditions change. Ideally, one should pay attention to both and not be afraid to adapt.

Knowing yourself and your situation, then, is as much a key to successful investing as picking the right assets. Personal and portfolio Issues will determine your best strategy. Now that you've scored your questionnaire and have quantified those issues-- like commitment, experience, education, type of account, relative size/importance of account time for maintenance, investment time horizon, etc., use the table below to gauge which strategy provides the best fit.

CRITERIA

Active Management

(Market Timing)

Passive Diversification

(Buy and Hold)

Experience Required

Moderate/High

Low/Moderate

Maintenance Required

Moderate

Low

Time Horizon

Short/Medium

Long/Medium

Taxable Account

High trading costs

Low trading costs

Tax-Deferred Account

Moderate trading costs

Minimal trading costs

Account % of Total Assets

Low/Moderate

Moderate/Large

Passive management requires less experience and less ongoing maintenance than active management. Trading costs, which include capital gains taxes in taxable accounts, are lower in passive portfolios than they are in active portfolios with higher turnover. Passive management, however, requires a longer time horizon. Active management can cut major losses and limit drawdown. Buying and holding through periodic bear markets (every six to eight years), however, can require years of “recovery time” afterward. Because of the higher cost and additional attention that active management requires, passive portfolios have traditionally formed the core or highest percentage of most investors’ asset base. Artificial intelligence, however, is lowering costs and changing that.

Ability & Willingness to Accept Risk Is Key

Ability and willingness to accept risk is probably the most critical personal input into a successful investment strategy. Now that you've scored your questionnaire and have defined your ability and willingness to accept risk, use the table below to gauge the best strategic fit.

CRITERIA

Active Management

(Market Timing)

Passive Diversification

(Buy and Hold)

Risk Profile

Aggressive/ Moderate

Moderate

Asset Volatility

High/Moderate

Moderate

Portfolio Volatility

High

Moderate

Risk and gain are directly correlated. Making more money requires taking more risk. Since active portfolio management costs more (trading costs plus time) than passive strategies, it requires a greater return to match the net gain from passive strategies. Earning a greater return requires absorbing more risk. Higher risk (active) portfolios tend to be more volatile over time than lower risk (passive) portfolios. This isn’t due so much to basic asset volatility, which may be the same for both strategies long term, but due rather to the shorter time frames associated with active management. Active portfolio changes tend to occur when asset volatility is above average.

What Works and When?

Face it: the first thing investors look for in a strategy is performance. Some strategies outperform in bear markets and others in bull markets. In addition, relative strategic performance can vary as different exogenous forces come to bear on the financial markets. 

Investors can get impatient, wondering “What has my strategy done for me lately.” The answer is not solely about current performance, it is also about what can happen at the extremes. How a strategy behaves in secular (long term) bull and bear markets is just as relevant as what it is doing at the moment.

CRITERIA

Active Management

(Market Timing)

Passive Diversification

(Buy and Hold)

Bear Market: Drawdown Risk

Low

Moderate/High

Recovery Period: Gains

Low

High

Bull Market: Gains

Moderate/High

Moderate/High

Active strategies generally carry less drawdown risk than passive strategies in bear markets. They also tend to lag passive strategies during the initial recovery period that follows a bear market.

Investment Vehicles: Focus on ETFs

Active and passive investment strategies can incorporate a variety of asset vehicles-- stocks, bonds, mutual funds, commodities, options, futures, and so on. The focus here is on exchange-traded funds or ETFs. ETF’s are funds, but unlike mutual funds, which are priced once at the end of each day, ETF’s trade throughout the day like a stock.

Since funds are essentially portfolios, their management strategies also fall into the same two basic flavors: (1) passively managed index funds and (2) actively managed “smart-beta” funds. In both cases, ETFs provide a high level of diversification within their specific asset class. Used together, they can provide a globally diversified portfolio of equity, income, and other assets.

Index ETFs

Index funds are passive. Index ETFs offers instant diversification in a tax efficient and cost effective investment due to minimal research cost and less turnover. Other advantages of a broad-based index ETF include less volatility than a strategy specific fund, tighter bid-ask spreads (so orders are filled easily and efficiently), and attractive fee structures. The disadvantage is that they are tied to an index and if the index underperforms, so will the ETF. Index funds generally form the basis for more actively managed smart-beta funds and for do-it-yourself asset allocation strategies.

Smart-beta ETFs

Smart-beta ETFs, also called “factor investing” or “strategic beta”, are based off a twist on a mainstream passive index. Basically, they are another version of indexing, but a more active one that takes into account an increased level of granularity when the choosing which securities in the index the ETF will under or over-weight. Common factors considered in factor investing include style, size and risk.

ETF Asset Classes: Equities, Income, and Other

ETFs slice and dice the global financial markets in myriad ways. Traditionally, there are three broad asset classes: Equities, Income, and Other. “Other” refers to assets that do not fall into the stock or bond categories. It includes commodities including precious metals, carbon fuels, and basic materials, as well as currencies, real property, etc. ETFs usually sub-divide the three basic asset classes into three geographic regions: domestic (US), international (ex-US), and World. We do not cover them all here. The table below provides a general overview of what’s out there, and the areas we’re following.

ETF Location

Equity Index

Equity Smart

Income Index

Income Smart

Other Index

Other Smart

US only

YES*

YES**

YES*

--

--

--

International-ex US

YES*

--

--

--

--

--

Total World

--

--

--

--

YES*

YES**

*We incorporate equity, income and other index funds into Index Moose, as well as US Sector Moose and TSP Moose. **We use smart beta equity and asset allocation funds in Strategy Moose and TSP Moose. Smart-beta asset coverage will be expanded in time as a wider selection becomes available.

Asset Allocation Strategies

Those looking for a diversified portfolio that balances their risk have two options: (1) build it yourself out of index funds, or (2) or use a smart-beta ETF (either an asset allocation fund or a lifetime fund.)

Global Aggressive Allocation—A smart beta fund that diversifies across asset classes and subgroups using ETFs-- focusing on top-down allocation rather than bottom-up security selection. Large allocations to indexes representing major asset groups: US large and midcaps, international equities and broad bonds are accompanied by smaller allocations to emerging market equities, US small-caps, high-yield bonds, REITs and TIPS. It is "aggressive" due to its higher allocation to equities over fixed income (about 80-20). It differs from target-date funds in that the asset mix is relatively static, rather than following an increasingly conservative glide-path. It is for buy-and-hold investors with a very long time horizon.

Global Moderate Allocation-- A smart beta fund that diversifies across asset classes and subgroups using ETFs-- focusing on top-down allocation rather than bottom-up security selection. Large allocations to indexes representing major asset groups: US large and midcaps, international equities and broad bonds are accompanied by smaller allocations to emerging market equities, US small-caps, high-yield bonds, REITs and TIPS. It is "moderate" due to its equal allocation between equities and fixed income (about 50-50). It is for buy-and-hold investors with an intermediate to long-term time horizon.

Apart from the static, diversified asset allocations mentioned above, this site is a long time proponent of targeting the best performer out of a low-correlation, diversified set of assets. Instead of buying and holding several asset classes through thick and thin, targeting uses momentum to isolate the best performing asset at the time, investing the entire portfolio in than asset.

Index Moose— A do-it-yourself global allocation strategy that targets the best performing index ETF out of set of nine-- focusing on top-down allocation rather than bottom-up security selection. Momentum is used to make 100% portfolio allocations to selected indexes representing major asset groups: US large and small-cap stocks, European, Latin American, Japanese, and other Asian equities, very long Treasury bonds, gold bullion, and cash. It is for active investors with a short to intermediate time horizon.

The Index Moose momentum model was developed in the late 1980’s when computers were young and the internet was just getting started. Retail investment opportunities have increased exponentially, especially over the last five to seven years. One can buy a momentum model wrapped in an ETF these days, along with just about any other strategy imaginable. So called “smart-beta ETFs”; blur the line between active and passive; and they’re a godsend for anyone who shares in the quest to keep it simple.

US Equity Strategies

Investment strategies have been “automated” for awhile, first using mutual funds, and more recently through smart ETFs. In the smart-beta world, equity strategies are far more prevalent than income or other strategies. Moreover, there is considerably more interest in US equity strategies than in international or global equity strategies. This site evaluates the current relative strength of seven of the most popular ETF equity strategies specific to the US market. International smart-beta ETFs may be added later, as more offerings become available.

US Equal Weight Stock Strategy— A smart-beta ETF that takes all the stocks in the S&P 500 and weights them equally, greatly increasing the footprint of smaller S&P 500 stocks. This results in a higher beta (more systemic risk) for the portfolio, but it also lowers concentration, reducing blow-up risk from any one name. Some sector biases are possible, as this ETF does not equal-weight sectors as some peer equal-weight ETFs do. Quarterly rebalancing implements the contrarian theme baked into all equal-weight plays: sell winners and buy losers.

US Equity Momentum Strategy— A smart-beta ETF that selects US stocks that have steadily increased in price lately. It makes its selection by looking at both 6 and 12-month returns, scaled by the volatility of returns over the past three years In order to find stocks with a smooth, positive trend line. It’s small-basket portfolio (it only ever holds between roughly 100 and 350 different stocks) makes large sector bets and carries high market risk.

US Growth Stock Strategy— A smart-beta ETF that tracks an index of US large-cap, mid-cap, and small-cap growth stocks based on a fundamental screening process that only uses two factors-- growth forecasts and historical price/book-- to identify firms with growth characteristics.

US High Dividend Stock Strategy-- A smart-beta ETF that identifies high-dividend-paying US companies (excluding REITS) by ranking forecast dividends over the next 12 months. Firsts ranked in the top half are then weighted by market cap instead of dividend size, offering a more conservative approach to high dividend yield.

US Low Volatility Stock Strategy— A smart-beta ETF that tracks a volatility-weighted index of the 100 least-volatile stocks in the S&P 500. Selecting about 100 S&P 500 stocks with the lowest daily volatility over the past year, SPLV does not consider correlation among stocks, thus producing a basket of low-volatility stocks, not a minimum volatility portfolio, Volatility-based selection and weighting typically drive the ETF’s market cap and beta (systemic risk) lower.

US Stock Fundamentals Strategy— A smart-beta ETF that tracks an index of US large-cap and mid-cap stocks, selected and weighted by high ROE, stable earnings growth, and low debt/equity, relative to peers in each sector.

US Value Stock Strategy— A smart-beta ETF that tracks an index of US large-cap, mid-cap, and small-cap value stocks based on a fundamental screening process that uses three ratios-- book-to-price, earnings-to-price, and sales-to-price-- to identify firms with value characteristics.

Income, and Other Asset Strategies

Currently, there are far fewer smart-beta bond and commodity ETFs than there are in the equity space. The narrow selection of smart-beta funds and their lack of extended performance history make index ETFs more suitable in the bond and commodity space for now.



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