Circumventing The Wall of Worry

Clients often tell us that a unique feature of our tactical investment strategies is the process by which we “handoff” exposure among asset classes, from weaker to stronger.

Let’s use emerging markets as an example to illustrate our approach. Within our diversified portfolios, our systematic investing rules dictate when to increase and decrease this exposure based on trends within the asset class. If a downtrend forms, exposure is reduced. That begs the question of where the exposure is sent. Many tactical managers will send it to cash or a lower volatility asset, such as fixed income. This is also something we will do if certain conditions are met, but we don’t think it should be the first or only option.

Instead, we have created a process for systematically moving along a chain of similar assets in search of stronger, positively-trending markets that may offer greater return potential than fixed income or cash. We call this our risk handoff strategy.

Risk Handoff Strategy

Using the emerging markets example again, instead of moving directly to cash, we will first look at the next closest comparable asset class. Within our portfolio construct, based on volatility and correlation, the next asset is foreign developed equities. If foreign developed equities are in an uptrend, we will move the vacated emerging market exposure there. If not, we will look at the next closest (U.S. equities) and so on. After all other equity-like options are exhausted, we end up with fixed income or cash equivalents.

You may be asking why we bother with the additional steps. After all, this process is not without some potential cost in the form of more trades, possibly resulting in short-term capital gains.

Well, our entire systematic investing process is rooted in a large amount of time and research that backs our conviction in efficacy data. The risk handoff strategy is no different. We believe a significant opportunity for outperformance exists versus a passive benchmark (and other tactical strategies) when we utilize a simple yet sophisticated series of steps to ease away from weaker assets. This is not a predictive process but one that leans heavily on the idea that trends are more likely to persist than end.

Here & Now: Our Handoff to U.S. Equities

This month’s set of allocation changes offers a great example of what we described above. Both foreign developed and emerging market equities are experiencing downtrends, resulting in us shifting some of this exposure to the U.S.

During the last decade, there have been long stretches where U.S. equities have vastly outperformed their international peers:

• U.S. – almost 200% return (Total Stock Market ETF Vanguard, VTI)
• Foreign developed – 53% return (FTSE Developed Markets Vanguard, VEA)
• Emerging markets – 32% return (FTSE EM ETF Vanguard, VWO)

Compare those returns to the US Aggregate Bond Ishares Core ETF (AGG), which returned only 12%, and you see the potential value in being able to systematically shift exposure over time to stronger asset classes rather than immediately move to fixed income. We believe this is a key component in maximizing compounding, as well as an area where trend following shines.

In addition to this long-term perspective about the relative strength of U.S. equities, let’s consider some shorter-term context.

In last month’s Note we highlighted how 2023 was the third-best start for the S&P 500 in 30 years of history. In years that started strong, the average return for the remainder of the year was approximately 9.4%, as highlighted by the graphic from last month:

Best Starts to the Year for the S&P 500

Source: GFD, SPY, 2/1/1993 to 7/26/2023

Given the recent tendency of U.S. equities to outperform other asset classes over both short- and long-term timeframes, we have high conviction in this being a good place to handoff international equity exposure in times like now, when emerging markets and foreign developed are in downtrends. Of course, this doesn’t guarantee anything in terms of outcome, but as a firm favoring methodical processes over unpredictable outcomes, we have confidence in the current positioning.

We are fond of saying that to be different in terms of results you must be willing to be different in terms of process. We think our risk handoff strategy is a great example of this. Being different can be scary, but the reward comes from seeing how our approach performs over the long-term and supports clients in staying on the course to reach their goals.