There has been a growing trend of reassessing and moving towards a more updated, post-modern portfolio theory (MPT) risk management and portfolio construction process. Traditional MPT portfolio diversification and risk management strategies historically divided portfolio holdings amongst core asset classes such as U.S. stocks, foreign stocks, emerging markets, bonds, gold, commodities, and cash. When subsequent major market corrections ensued with less than stellar results for MPT - especially when needed most - that resulted in further diversification efforts with more portfolio parameters and, in some cases, adding a more dynamic, tactical overlay.
This evolution has been inexorably continuing and has led us now into modernizing MPT by further diversifying portfolios across more asset classes, multiple investing methodologies, multiple portfolio strategies, multiple investing time frames, and multiple managers, as well as a further evolution of tactical strategies to what some are terming “tactical 2.0”.
To explore this further, the Institute was recently introduced to Drew Horter, President & CEO of Tactical Fund Advisors (TFA) and David D. Moenning, consultant to TFA and a TFA Subadvisor – a growing Cincinnati-based fund group providing risk-managed, multi-strategy mutual funds designed to dynamically adapt to changing market environments. In our discussion we wanted to explore their investment philosophy and process which they describe as a modernized approach to tactical investing, diversification, and portfolio design.
Hortz: Why do you believe that a tactical approach to investment management is superior to a passive, buy-and-hold strategy?
Horter: From our perspective, the answer is simple. We believe that if given a choice, few investors would intentionally remain fully invested in stocks during bear market cycles. Ask yourself: As an investor, do you really want to just sit there and take it the next time the stock market declines -20%, -30%, -40% or more?
Remember, the mathematics of loss are brutal. For example, a 31% decline (which according to Ned Davis Research, is the mean decline of the bear markets seen since the early 1900’s) requires a gain of more than 44% to breakeven. And if you lose 50% during a bear market, you will need to double your money to get back to where you started!
So, our thinking is, why not at least try to “lose less” the next time the bears come to call at the corner of Broad and Wall? The bottom line is we believe this is what tactical risk management is all about.
And speaking about trying, passive investors make no effort whatsoever to add alpha to their portfolios. Much like a sailboat, buy-and-holders simply set their portfolio allocation sails and let the market winds carry the portfolio where they may. On the other hand, tactical investors don’t just accept what the market provides, they actively manage their portfolios and adapt to changing environments. In short, a tactical manager seeks to create alpha and to manage risk, while passive investors do neither.
The overarching goal of the tactical, risk-managed approach that TFA espouses is to participate in bull market gains while striving to preserve as much capital as possible during those inevitable negative market cycles.
Hortz: In going beyond classical Modern Portfolio Theory (MPT), what do you consider to be the new state of the art diversification techniques needed in today’s portfolios?
Moenning: Traditional MPT portfolios diversify by asset class and geographic region. This was a good idea back in the 1960’s, when MPT originated. But that was before computers. Before ETFs. Before trading apps on cell phones. And definitely before high-speed algorithmic trading.
Today, markets move at the speed of light. And when a crisis occurs, diversification by country, region, or even asset type has little bearing. No, during difficult times, we believe there are really only two asset classes: government bonds – which go up during these tough times – and everything else, which tends to act like the U.S. Stock market.
We believe that modern times demand more modern solutions. Investors need to move beyond traditional diversification. Our view is that diversification by investing methodology and strategy, as well as by manager and timeframe represents a modern take on portfolio design and diversification.
Hortz: In implementing your multi-manager approach, how do you determine the investment strategies and subadvisors needed for your portfolio construction?
Moenning: There is a lot of science and math that goes into these decisions. But the basic premise is to understand that there is no single approach that works in all environments. All managers, strategies, methodologies, etc. can fall out of favor at times. Thus, the traditional approach to fund management is subject to what we call, “the singular failure.” The solution is to diversify that risk – among different investing methodologies, strategies, managers, and timeframes.
Getting back to your question, each of our funds has a specific objective. For example, we offer a series of tactically risk managed asset allocation funds catering to various risk tolerance levels (Conservative, Moderate, and Growth). Each of these funds has multiple managers, which are chosen for their specific area of expertise.
The approach we employ is a bit like managing a baseball team. You need to find the right combination of good defenders and strong offense in order to win games. So, like the major league baseball managers, TFA’s job is to combine managers that can play great defense with others that can hit for power, so to speak. Only, we have a lot of computer power to help us analyze and identify the right combinations.
Hortz: What risk mitigation strategies are built into your portfolios and investment process?
Horter: We employ a plethora of strategies designed to reduce exposure to risk during times of market stress. Each manager brings their own approach to the fund. For example, some utilize trend following approaches. Others focus on volatility. One of our managers utilizes derivatives to provide a set risk/return profile. Another employs econometric factors. Yet another approach incorporates non-correlated asset class exposures. The key is to diversify the strategies employed so that if one approach struggles, there will be others to pick up the slack.
Then there is the subject of timeframes. We believe that utilizing multiple timeframes is mission critical to successful risk management. You see, there are times when a shorter-term approach will work well – such as during the COVID market crash as the market moved quickly in one direction, and then the other. The key in these environments is to be nimble and quick.
However, in more normalized environments, such as we’ve seen in 2021, a longer-term approach is preferred. In this instance, simply staying on the bull train is the way to go. And since it is tough to determine which of these strategies is going to work “best” (an approach that is also fraught with risk), we turn to the idea of good old-fashioned diversification, but in a more modern fashion.
Hortz: How exactly do you orchestrate these different investment components and timeframes involved into a cohesive and effective investment strategy?
Moenning: We start with a lot of research on the various strategies available to us. We then determine an optimal allocation based on multiple criteria – incorporating measures, such as alpha, volatility, drawdown, Sharpe and Sortino ratios, among others.
We then stress-test the allocations in order to get a general understanding of what to expect during various market environments. Think 2008’s bear. The 2009 rebound. The low-volatility bulls of 2013 and 2017. The difficult years like 2011. And more recently, the COVID Crash - and the ensuing economic re-opening.
We know that all the managers won’t hit the ball out of the park in all markets. But the idea is to create a combination of strategies that provides the “smoothest ride” possible over what can often be a very bumpy road.
From there, we monitor the managers exposures, performance, volatility, etc. like a hawk. If a manager’s approach strays outside of its historical norms, our Investment Committee performs an attribution analysis to determine if the problem is outside expectations.
For example, if a manager’s approach falters – and the performance cannot be attributed to the market environment – the manager is put on heightened review and becomes subject to a reduction in allocation or removal.
Hortz: Any other thoughts or recommendations you would like to share with advisors
Horter: Actually yes, thanks for asking. In working with advisors over many years, we’ve learned it is critical for advisors to understand what to expect with tactical, risk managed strategies. For example, we believe advisors need to recognize that tactical risk management strategies CAN be expected to reduce exposure to market risk during severely negative environments, strive to “lose the least amount possible” during bear market cycles, and get it “mostly right, most of the time” during really big, really important moves.
However, it is important to understand that tactical risk management strategies CANNOT sell at the top and buy at the bottom of market cycle (this is a fool's errand), protect against ALL losses during negative markets and avoid EVERY bear market decline.
Armed with the proper expectations, we believe that a tactical, risk managed fund (or two) should be an integral part of every investor’s portfolio looking for heightened risk and volatility management.