|A version of this article previously appeared in the August 2022 issue of Morningstar ETF investor. Click here to download a free copy.|
Few investors can endure the ebb and flow of the market for years without changing their plan. There is a constant stream of information on earnings, inflation and job reports; up-to-the-minute market data and analysis are available to everyone. Investors of all skill levels hear the sirens call when they seize an opportunity to beat the market. Many investors tactically maneuver their portfolios in these situations, deviating from their long-term investment strategies to take advantage of anticipated short- or medium-term market movements. Others invest in tactical funds that intend to find these opportunities on their behalf.
The hindsight advantage makes it easy to uncover tactical strategies with market-beating backtests, but many fall short of the out-of-sample hype. There are a few battle-tested tactical exchange-traded fund strategies that can play a useful role in portfolios. Sector rotation and managed futures strategies have been around for decades and follow the same principles as momentum investing in stocks, but they use momentum in different ways.
Despite investors’ penchant for tactical trades, they are far less likely to invest in tactical funds. Here I’ll break down each strategy to see if they deserve a spot in a portfolio and, if so, how best to use them.
Benefit from sector momentum
Sector rotation strategies are typically an extension of momentum investing that focuses on sectors rather than individual stocks. There are many sector rotation strategies, but the simplest is to invest in the best performing sectors. I created a sector rotation model using the Ken French Data Library that includes monthly returns for 12 industry portfolios from July 1927 to June 2022.
The model calculated 12-month trailing returns excluding the last month and weighted the three best-performing sectors equally. Excluding last month’s returns circumvents the short-term reversal effect, where stocks that did well last month tend to do poorly the following month. The model is rebalanced monthly. The results in Figure 1 illustrate the effectiveness of the strategy compared to the broader market.
Momentum strategies exploit inefficiencies in human behavior. People are slow to absorb new information and tend to overreact as soon as they move. This underpins the phenomenon of investors earning worse returns than fund returns themselves. With this behavioral advantage in tow, sector rotation strategies have proven their effectiveness over the past century. And the model’s outperformance was not generated during a long-forgotten market event like the Great Depression. The annualized spread between the model and the portfolio across all industries has widened by 23 basis points over the past 20 years, meaning it has held its lead for almost a century.
This sector rotation strategy also benefits from its flexibility. Unlike, for example, a value strategy, the portfolio is constantly changing, so there is no relative strength against historical norms. There is no material difference in the model’s expected excess return if it loses against the broader stock market for six straight months. The model essentially follows a random path around the expected long-term outperformance of the market, allowing investors to add or remove the strategy from their portfolios at any time without catch-up effects.
What the model doesn’t capture is the trading costs of a high turnover strategy, which are a direct result of returns. Sector rotation funds also tend to charge significantly higher fees than broad equity funds. These costs weigh heavily on performance over the long term. And there’s also the risk that investor behavior could change over the long term, taking away the advantage of the strategy. Sector rotation strategies best fit within the equity envelope of investors’ portfolios due to their high correlation to the broader stock market. A high correlation to the broader market also means that the strategy’s ability to suppress downside risk is limited. The model narrowly beat the broader market when stocks were in a drawdown.
Sector rotation funds are limited in the ETF market. Several were launched in the last two years, but only three before 2020. Figure 2 shows their performance compared to the Morningstar US Market Index since early 2020.
Tactical asset allocation strategies aim to monetize short-term deviations from long-term expectations between asset classes. These strategies may take into account macroeconomic data, relative valuations and technical indicators. They enjoy market imbalances, which means they need to take a healthy dose of active risk.
There are tactical allocation strategies for all types of investors. For example, investors faced a dilemma when inflation started to accelerate significantly in April 2021, but the Federal Reserve called it “temporary.” Aggressive tactical allocation strategies are going all in on perceived opportunities and may have bought commodities in response to rising inflation risk. Moderate strategies reduce risk and offer an opportunity for some profit and may be tactically allocated to inflation linked government bonds. Conservative strategies aim to tactically remove risk from the table with a focus on capital preservation and may have switched to short-dated bonds. Finally, contrarian strategies look for misinterpretations of current risks and look for short-term reversals and in this scenario may have bought longer duration bonds.
Risk management with managed futures
Managed futures strategies are one of the most widely used tactical strategies in the market. Investors have traditionally accessed these strategies through Commodity Trading Advisors, or CTAs. There are myriad proprietary methods, but they are typically trend-following strategies that go long or short futures contracts across various asset classes such as commodities, stock indices, currencies, and fixed income.
The long-short portfolio across asset classes results in very low correlation to equities. Unlike the sector rotation strategy, managed futures strategies are best suited to diversify equity exposure and increase risk-adjusted performance over the long term. Because of this, they are best suited as a replacement for part of the fixed income envelope of a traditional 60/40 portfolio.
Figure 3 compares the performance of the Vanguard Total Bond Market ETF (BND) and the SG CTA Index, which tracks the daily performance of a pool of CTAs from early 2009 to July 2022. BND outperformed the CTA Index but showed significantly lower volatility and slightly crushed CTAs on a risk-adjusted basis.
However, managed futures strategies have performed very well as a hedge for equities in recent years. Their uncorrelated returns rose better than bonds when stocks plummeted. This adds value to portfolios with a moderate to high equity allocation. Figure 4 compares a 60/40 portfolio made up of 60% Vanguard Total World Stock ETF (VT) and 40% in BND, as opposed to a 60/20/20 portfolio where half of the BND weight is reallocated to the SG CTA Index.
The addition of another uncorrelated asset like managed futures improved the 60/40 portfolio despite the SG CTA Index’s terrible individual results. However, this strategy is not without caveats. First, managed futures strategies tend to come with high expense ratios, meaning you’ll likely be paying close to 1% in fees annually, which isn’t reflected in the analysis above. Also, “uncorrelated” does not mean “negatively correlated”. Stocks and managed futures funds will march to the beat of their own drums, meaning managed futures won’t always bail out stocks when things get worse.
Unlike sector rotation strategies, the optimal use case for CTAs is to hedge higher-yielding assets like stocks. That means investors have to withstand a portfolio drain if stocks experience an extended rally. All too often, investors dump their diversifying assets before they need them most.
The State of Tactical ETFs
Sector rotation and managed futures ETFs are relatively small in number and size. New tactical ETFs have been launched in recent years, but adoption remains low. Following their success in early 2022, net flows into managed futures ETFs have surged. And as I’ve shown, there are valid reasons to include these funds in your portfolio. But theory and practice diverge, and the costs add up to those funds. When used properly, these funds can capture momentum and add value to your portfolio. With managed futures strategies, a buy-and-hold approach makes sense over the long term.