It has been almost 10 years since the first waves of the housing bubble began rippling through the markets, eventually cresting into a global financial crisis. An important lesson that investors learned from those difficult circumstances was the need to capitalize on tactical opportunities while maintaining long-term strategic goals. Of the different approaches to portfolio construction, one that is gaining in popularity is the integration of exchange-traded funds (ETFs) into strategic and tactical asset allocation approaches to create well-diversified, cost-effective portfolios.

A strategic asset allocation approach is the long-term (i.e., a time horizon of more than one year) asset mix that can provide specific ranges to help investors reach their financial goals, given their personal objectives and constraints. Tactical asset allocation, on the other hand, consists of shorter-term adjustments that aim to add value by exploiting changing markets.

“One way to explain the difference between strategic and tactical asset allocation is with a driving-related analogy,” says Paul Taylor, Senior Vice President and Chief Investment Officer, Asset Allocation at BMO Asset Management Inc. “Think of strategic asset allocation as the road that takes you from the start of your journey to where you want to end up, while tactical asset allocation is everything that happens ‘between the guard rails’ on this road, from manoeuvering through traffic to adapting to changing weather conditions.

” To see how this manoeuvering can work in a portfolio, consider the example of the significantly disparate returns among equity markets in 2015. As at December 31, 2015, the one-year returns (in Canadian-dollars) for the S&P/TSX Composite Index, the S&P 500 Index and the MSCI EAFE Index were -8.32%, +21.59% and +19.46%, respectively.1 If a portfolio’s strategic asset allocation was set at 30% each for Canadian, U.S. and EAFE equities, then an astute asset allocator could have added value tactically by temporarily decreasing the portfolio’s Canadian equity exposure to 25%, and adding 2.5% each to the portfolio’s U.S. and EAFE equity exposures.

How to achieve “true” diversification

True diversification is key to effective portfolio management, so it’s crucial to implement a sound approach. Taylor suggests a five-step portfolio diversification process. First, start by allocating assets between equities and bonds, which is the “risk-on/risk-off” step of the process. Second, within equities, choose between developed markets and emerging markets.Third, within developed markets, make regional allocation calls (e.g., Canada, U.S., Europe, Asia). Fourth, focus on bonds and allocate among credit, duration and regional exposures. Fifth, make currency decisions, which is an increasingly important consideration in today’s markets.

The role of ETFs in asset allocation

One growing trend in portfolio strategies is the use of ETFs. Given their flexibility and fluidity, ETFs can allow for greater precision compared to broad-focused mutual funds. For example, not only can ETFs instantly offer diversified exposure to U.S. equities, but you can also move easily between hedged or unhedged positions based on your view of currency exchange rates. Similarly, an asset allocator may want eurozone exposure without the need to undertake detailed securities analysis or hire a specialized team to manage a European sleeve. With ETFs, you simply apply a basic screen, make your selection and gain the desired eurozone exposure in one easy trade.

ETFs can also serve as useful tools within other asset allocation strategies. They can be used for the “core and explore” component of a portfolio, where broad-based ETFs or mutual funds act as the core of a portfolio’s allocation, while highly focused ETFs can act as satellites that explore smaller markets or niche sectors. If you believe the market is undervaluing financials, for example, you can tactically allocate assets into a financials sector ETF, while maintaining your broad market exposure. Capital markets are generally efficient, but any slight deviations offer the opportunity to make short-term tactical adjustments in a portfolio.

ETFs can also form part of a tax-loss strategy, and are ideal for advisors who add value via tax-planning services. A client in a capital gains position can sell a security – perhaps the stock of an oil producer – at a loss, and then purchase an energy sector ETF. In doing so, the client offsets some or all of their capital gains with the loss, while maintaining energy sector exposure and preserving the established strategic asset allocation.

Furthermore, ETFs can be used as a portfolio completion strategy. If your client owns banks stocks and other large-capitalization Canadian equities, for instance, you can round out this client’s Canadian equities exposure with a Canadian small-cap ETF.

Whether you choose ETFs or ETF-based mutual funds, you will have the building blocks required for effective strategic and tactical asset allocation, helping you create strong, risk-adjusted portfolios for your clients.

1. Source. Bloomberg as of December 31st, 2015.

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