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The Truth Behind Tactical ETF Investing

March 28, 2013 by  

By John Bogle

The past half-decade or so has seen a significant change in the mindset of investors. Prior to 2007, “buy and hold” was the predominant investment philosophy. Investors were conditioned to ride out market cycles and to level off the peaks and valleys through periodic investments via an investment strategy called dollar-cost-averaging (DCA).

Following the market crash of 2007 and the multi-year financial crisis that followed, the mantra changed from “buy and hold” to “do something now!” Watching their hard-earned money disappear, even as investment experts urged them to stand fast and take no action, shook the conviction of many former buy-and-hold advocates and generated significant frustration. The result was a shift that led to a big increase in the popularity of tactical investment strategies, with tactical exchange-traded fund (ETF) strategies at the forefront of the movement.

The Psychology of the Shift

Buy-and-hold investors were taught to ignore the day-to-day fluctuations in the financial markets and to focus instead on the long term. For decades, this practice helped investors slowly build wealth. When the crash of 2007-2008, and the bear market that followed, wiped out 40% of the holdings in many portfolios, investors who were close to retirement saw a substantial portion of their wealth disappear. Younger investors lost much of the little savings they had, and many investors of all ages lost faith in the time-tested buy-and-hold philosophy. They suddenly felt like they were watching their hard-earned savings disappear and were doing nothing to stop it.

The Rise of ETFs

In an environment where “buy-and-hold” felt like “wait and lose,” investors not only wanted to take action, but they became increasingly aware of the fact that they were paying mutual fund managers a lot of money in fees. Paying those fees can feel justified when portfolios are posting double-digit profits, but only the most stalwart of investors are willing to sit back, relax and pay for investment management that results in double-digit losses.

The situation resulted in an environment where exchange traded funds intuitively felt like the answer for an increasing number of investors. ETFs are less expensive than mutual funds. They can be traded intra-day like stocks. They offer broad diversification across asset classes, convenient specialization within asset classes and don’t tout stock-picking as the key to making money. This combination of fast trading, plentiful investment options, a novel investment approach and low costs attracted a lot of investors.

The Tactical Evolution

Investment providers took notice of the billions of dollars flowing into ETFs and began to build pre-packaged portfolios using ETFs to construct model portfolios along the efficient frontier. The portfolios often begin with a base allocation that was typical of similar mutual fund models. Their allocations often range from about 20% stocks/80% bonds to 80% stocks/20% bonds and just about everything in between. Some offer portfolios geared strictly to income generation, others to growth and some a combination of both.

Rather than offer a mechanical, automatic rebalancing scheme that seeks to maintain the original allocation, these strategies make intentional trades in an effort to adjust to ever-changing market conditions. For example, a 60% stock/40% bond model might move to 65% stocks/35% bonds, if the stock market appears to be poised for gains, and then back again to 60% stocks/40% bonds when conditions warrant.

This intentional rebalancing could be done once a month, once a week, once a day, once a minute, or (in theory if not in practice) if market conditions warrant, as fast as the portfolio manager can type. In addition to adjusting asset allocation in anticipation of changing opportunity in various asset classes, ETF portfolios can engage in sector rotation, country rotation, leverage strategies and a myriad of other potential combinations and strategies.

If appealing to investors’ desires to make tactical trades and explore new concepts for making money wasn’t enough enticement, a number of tactical ETF strategies have tilted their marketing efforts to focus on risk management. This approach is not about stock picking or an effort to outperform a given benchmark. Quantitative models are used in effort to reduce volatility and limit losses. For example, if market conditions are deteriorating, the model can be set to trigger trades that result in a more defensive position once a certain threshold has been passed. The same type of logic exists on the upside, with the defensive position traded for a more aggressive stance once certain indicators are noted.

Such strategies look and sound logical. They have a visceral sort of appeal at a time when investors have fresh memories of significant market declines and multi-year bear markets that decimated portfolio values. They also offer diversification, systematic investment processes, built-in risk management strategies and investment philosophies that sound reasonable and intuitive.

The Other Side of the Coin

While tactical ETFs have attracted significant sums of money, they are not without their critics. John Bogle, founder of Vanguard Group, has been a long-time critic of ETFs, even though they have been embraced by the firm he once ran. Bogle and others have pointed out that ETF strategies encourage rapid trading and speculative behavior. Long-term investors, such as those saving for retirement, should have no need to make rapid-fire trades, nor should they base their multi-decade investment strategy on minute-by-minute market reactions. Such strategies can easily be categorized as just another flavor of market timing, which is not a strategy that has been demonstrated as effective over the long term.

It is a well-known fact that actively managed mutual funds have been losing assets as investors accept the reality that most of them fail to beat their benchmark indexes. This has led to significant inflows to passive investment strategies that seek to replicate the returns of a given benchmark index rather than outperform that benchmark. Tactical ETFs are simply active management based on trading ETFs rather than stocks. Continuing this train of thought, if the experts have failed to demonstrate skill at stock selection, what reason is there to believe that they are any better at selecting ETFs, timing the trends in the market place or making any other type of active investment management decisions?

While there are a variety of arguments that the investment approach employed by tactical ETF strategies involves factors such as asset class movements, market direction, sector selection and risk management, it’s easy to understand the perspective that these approaches are simply various flavors of active management.

Expense is another interesting consideration cited by critics. While individual exchange traded funds are often available for fee levels that are just a fraction of the fees charged by comparable mutual funds, tactical ETF models are more expensive than standalone ETFs. Beyond that, a spate of high-profile trading glitches and ETF closures has shown that all ETFs are not created equal.

The Bottom Line

What makes tactical ETF investing strategies so popular? Is it the triumph of hope over reality? Is it a reflection of our digital, instant-news society bleeding over into the investment world and selling the idea of “instant” trading, even though that rarely happens? Or perhaps it’s the psychological need to feel like you can take action when the financial markets decline. Whatever the answer, the strategies continue to grow in popularity and continue to attract assets as well, bucking the larger trend away from active management.



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