Tactical ETF Portfolio Practices From the Pros

Perhaps the most important decision faced by an investor is the asset-allocation decision--how to allocate assets along the risk-return spectrum. While it is common to spend a great deal of time researching individual stocks or fund managers, studies have shown that asset allocation can add at least as much value as selection within an asset class. There are two general approaches to asset allocation: strategic and tactical.

Strategic asset allocation has its roots in Modern Portfolio Theory and relies somewhat on the belief that markets are efficient, or at least that it is difficult to exploit market inefficiencies. Historical return data can be used to estimate the risk premium and correlations from a variety of asset classes. With this information and the investor's risk tolerance, target portfolio weights are established. Because long-term historical data does not change much from year to year, a strategic asset allocation does not change much and only requires occasional rebalancing or a reassessment of investor risk tolerance.

Tactical asset allocation, on the other hand, takes the changing market environment into account and utilizes shorter-term forecasts to propose deviations from the strategic allocation. This is a more active approach that attempts to exploit market inefficiencies, so it requires an investment process that develops a return forecast beyond just taking the average historical return. The specific strategies used in tactical asset allocation were the subject of a panel discussion at the Morningstar ETF Invest Conference.

Larry Cao, a senior consultant with Ibbotson Associates, uses long-term return data to form the building blocks of a portfolio. But this strategic approach is augmented through the use of behavioral factors, namely short-term continuation and longer-term reversal. Just as individual stocks exhibit momentum, so do industries, sectors, and even factors. A factor refers to any characteristic that is known to explain returns or risk, such as size or valuation.

Mark Scheffler, the senior portfolio manager and founder of Appleton Group, also uses a behavioral approach. He describes his process as relying on the "wisdom of crowds" and believes that the market is efficient at spotting trends. The elevated volatility that we have experienced lately is evidence of disagreement among market participants. This lack of market consensus is why he currently has a lot of cash sitting on the sidelines; once a sustainable trend does emerge, he will be ready to take advantage. While there is disagreement on the direction of the U.S. and eurozone economies, there is widespread agreement that emerging markets will enjoy strong economic growth. Outside of cash, Scheffler's largest equity holding is  Vanguard Emerging Markets Stock ETF (VWO). The next largest equity holding is  iShares Dow Jones US Real Estate (IYR). Over the past year, it is up 28% while the S&P 500 is up 9%. Because real estate fell harder during the financial crisis, its rebound has been stronger.

While Cao and Scheffler use trends in market prices, Astor Asset Management managing partner Rob Stein uses trends in fundamental data, namely employment data. He believes that firms change staffing levels in response to changes in underlying demand and that by monitoring these changes, he can rotate into sectors experiencing growth. Currently, his portfolio is overweight tech hardware and health-care sectors and underweight consumer-related sectors and sectors requiring a lot of leverage, such as financials. With the earnings yield on stocks (the inverse of the price/earnings ratio) surpassing the yield on bonds, he sees attractive opportunities in stocks relative to bonds. The notion that equities look attractive relative to bonds echoes the sentiment expressed by Vanguard's Fran Kinniry. To implement this idea, he has chosen  SPDR S&P Dividend (SDY), which provides the added protection of a high dividend yield. Over the past year, SDY has outperformed the S&P 500, indicating investors' increased interest in dividend-paying stocks. For his tech exposure, he has chosen  iShares S&P North American Technology-Semiconductors  and  PowerShares QQQ .

Dan Farley, global head of investments for SSgA's Multi Asset Class Solutions team and the keynote speaker at the conference, was not on this particular panel but did share that he has seen a dramatic increase in the use of ETFs for asset allocation. The three panelists are big believers in ETFs, as the advantages of ETFs are even more pronounced for asset allocators. ETFs provide a precise tool with which to implement a portfolio. Because ETFs typically follow transparent indexes, the investor is able to control the exposure to each asset class directly, without having to monitor an active manager or incur the higher costs that active management entails. ETFs trade throughout the day, not just at the end of the day. While most ETFs are liquid, large trades can still be facilitated through the ETF creation/redemption process. Additionally, the proliferation of ETFs covering a wide variety of investment options means that there is an ETF in just about every asset class, even in areas of the market that were historically out of reach for the average investor.