In the ever-fluctuating world of investing, asset allocation stands as a beacon of strategy, guiding investors through the seas of market volatility.

At its core, asset allocation is about creating a balanced portfolio that aligns with your risk tolerance and financial goals.

But what happens when the winds change direction, and the financial landscape transforms? This is where the wisdom of evolving with the markets comes into play.

For decades, the traditional set-and-forget strategy served as the cornerstone of investment plans. Investors would meticulously choose their asset mix, often a balanced composition of stocks, bonds, and cash, based on their risk profile and long-term objectives.

However, as we navigate through the complexities of modern financial markets, the need for a more dynamic approach becomes apparent. This is not about making drastic, high-stakes shifts in your portfolio but rather adopting a philosophy of incremental adjustments within established bounds.

Drawing from over 30 years of experience in capital markets as a portfolio manager, I've observed firsthand the benefits of making tactical tweaks to an investment strategy.

These adjustments are not about chasing market trends or reacting impulsively to short-term volatility. Instead, they're about recognizing that as your life circumstances evolve and market conditions shift, so too should your asset allocation.

Strategic vs. Tactical Asset Allocation

Understanding the dual nature of asset allocation is crucial for navigating the ever-changing investment landscape. This distinction lays the groundwork for adopting a dynamic approach to managing your investment portfolio.

Strategic Asset Allocation: The Long-Term Plan

Strategic asset allocation is the bedrock of your investment strategy. It involves setting target allocations for various asset classes (such as stocks, bonds, and cash) that align with your long-term financial goals, risk tolerance, and investment horizon.

This allocation is based on historical performance data and the fundamental belief that, over time, markets will reward long-term investors for the risks they take.

The strategic asset allocation is designed to be relatively stable, with adjustments made periodically to rebalance the portfolio back to its original asset mix. This ensures that the portfolio remains aligned with the investor's initial risk and return objectives.

Tactical Asset Allocation: Flexibility Within Framework

Tactical asset allocation, on the other hand, allows investors to make short-term deviations from their strategic asset mix to capitalize on temporary market opportunities or mitigate risks. These are deliberate, measured adjustments based on current and anticipated economic and market conditions.

Tactical allocation requires an understanding of market trends, and economic indicators, and the ability to forecast financial events with some degree of accuracy. It's a more active investment strategy that seeks to enhance returns or reduce risk by exploiting short- to medium-term market inefficiencies.

The Case for Dynamic Asset Allocation

The financial markets are a reflection of the global economy's constant state of flux. Economic cycles progress, geopolitical landscapes shift, and market sentiment sways, all of which can affect asset class performance.

Static investment strategies that ignore these changes risk being left behind, as they may not be positioned to capitalize on emerging opportunities or shield against looming threats.

Dynamic asset allocation acknowledges this reality, allowing investors to adjust their exposure to different asset classes within the confines of their strategic investment plan.

For example, consider an investor with a strategic asset allocation of 60% equities and 40% bonds. If economic indicators suggest an upcoming period of stock market volatility, the investor might temporarily shift to a 55% equities and 45% bonds allocation to reduce risk.

Once the volatility subsides, the investor would then shift back to the original allocation. These tactical adjustments are not about timing the market per se but rather about making informed decisions that reflect the current economic environment.

The benefits of dynamic asset allocation are twofold.

• It allows investors to respond to shorter-term market conditions without losing sight of their long-term investment objectives.

• It leverages the investor's knowledge and experience to make nuanced decisions that could potentially enhance portfolio returns or reduce volatility.

The Role of Market Conditions in Asset Allocation

The financial markets are akin to a vast, interconnected ecosystem, constantly influenced by a myriad of factors including economic data, monetary policy, corporate earnings, geopolitical events, and investor sentiment.

These conditions can cause significant fluctuations in asset prices and market dynamics, presenting both risks and opportunities for investors. Understanding how these conditions impact asset allocation is essential for making informed, tactical adjustments to your investment strategy.

Economic Indicators and Market Performance

Economic indicators such as GDP growth rates, unemployment figures, inflation data, and consumer confidence indexes offer valuable insights into the health of the economy and potential market directions.

For instance, strong economic growth and low unemployment may signal robust market conditions, favoring an increased allocation to riskier assets like equities.

Conversely, rising inflation or declining consumer confidence might suggest a cautious approach, with a tactical shift towards more stable investments such as inflation-protected bonds or precious metals.

Geopolitical Events and Investor Sentiment

Geopolitical events — from elections and trade agreements to conflicts and diplomatic tensions — can have immediate and profound effects on market sentiment and performance.

These events often lead to increased volatility, as investors react to uncertainties and potential implications for global markets. During such times, a dynamic asset allocation strategy can help mitigate risk by temporarily reducing exposure to affected regions or sectors, or by seeking refuge in safer asset classes.

Assessing Asset Class Attractiveness

In the context of dynamic asset allocation, I typically evaluate asset class attractiveness based on four critical factors:

• Valuation

• Growth potential

• Income generation potential

• Sentiment, including momentum and the technical stage of the investment.

These considerations are analyzed within the broader macroeconomic environment, using our proprietary Risk Aversion Index (RAI). The RAI serves as a comprehensive gauge of market sentiment, combining various indicators to provide a nuanced understanding of investor risk appetite and the potential impact on different asset classes.

In addition, we analyze asset class volatility and correlations to arrive at a target asset allocation mix that meets the risk and return requirements. Periods of high volatility are typically associated with lower returns to risky assets such as equities while periods of calm lead us to more aggressive allocations. Many advisors assume that volatility and correlations are static but the reality is that capital markets are always moving and evolving.

This methodical approach allows for a more refined analysis of when to make tactical adjustments to the portfolio, ensuring that decisions are grounded in a thorough assessment of market conditions and asset class fundamentals.

Current Asset Class Views

As of the end of March 2024, our current stance could be categorized as mildly aggressive. Our Risk Aversion Index (RAI) is in the Exhuberant Zone with nothing pointing to an eminent shift in investor sentiment.

Equities:

Even though we think that US Large Cap equities, especially the largest weights in the index, are stretched from a valuation standpoint we believe that recent innovations such as artificial intelligence (AI) and blockchain implementations have such tremendous promise that we are willing to continue on the bandwagon with the expectation that future earnings growth will justify current valuations.

We are anticipating that US Small Cap will close the performance gap relative to US Large Cap the longer the bull run continues. Small Caps look inexpensive relative to large caps and should benefit from a robust economic backdrop in the US.

Similarly, we see International Equities performing more in line with US Large Caps. International equity indices have less growth potential but they offer greater stability and income potential along with much cheaper valuations than US stocks. In addition, we believe that the US dollar will start depreciating relative to the Yen and Euro leading US-domiciled investors to enjoy a positive currency return alongside attractive local currency market returns.

Our view on the attractiveness of Emerging Market Equities is only tainted by ongoing economic problems in China. Chinese equities constitute about 1/3 of the MSCI EM Index. We see Chinese equities as massively undervalued relative to the rest of the world with the discount a function of uncertainty regarding government policy, slowing economic growth, and ongoing tensions with the US.

Bonds:

Bonds are the hated asset class at the moment. Bonds failed to protect investors during the 2022 bear market and are still below breakeven on a 3-year basis. Year-to-date bonds have continued to underperform.

We do not see much changing until the Fed steps in to cut short-term rates. Lower rates would translate into higher bond returns but the effect would be short-term.

At the end of the day, the expected return of bonds is primarily driven by the yield on the investments. Capital gains due to lower rates are a bonus but we’re unlikely to see rates trending down to any significant extent anytime soon. In addition, with inflation running around 3%, there is not enough compensation for purchasing power risk. We remain underweight bonds.

Alternatives:

We are warming up to Real Estate (REITS) as interest rates are expected to move lower once the Fed takes action. We like REITS especially those not exposed to the commercial real estate market.

Attractive valuations and yields back up our position. We recognize that this is a bit of a contrarian position to take as REITS have seriously underperformed but we think the worst is behind us. It’s also consistent with our philosophy that a well-designed asset allocation strategy should contain both growing asset classes as well as contrarian bets. A small overweight to REITS seems justified given current conditions.

In terms of Commodities, we are selling into strength. Oil is moving higher due to geopolitical risk, not economic reasons. We see the role of Commodities in a portfolio as almost done at the moment given the downward shift in inflationary expectations. We view a small holding in Commodities as a hedge should inflation re-ignite, but not meriting a full position anymore.

Cash:

Given the uncertainty of interest rate cuts and the inverted yield curve, we still like cash.

Cash is yielding more than long-term bonds currently and having cash available allows for tactical flexibility should market conditions change. At the moment, cash can be viewed as a proxy for bonds.

Implementing Incremental Adjustments within Strategic Bands

Making incremental adjustments in response to market conditions requires a disciplined approach and a clear understanding of your strategic asset allocation framework.

These adjustments should not be drastic swings but rather slight shifts within predetermined bounds to avoid overreacting to short-term market noise.

These adjustments should be both measured and purposeful, aimed at enhancing returns or mitigating risks, all while remaining anchored to the investor’s overarching strategic plan.

The first step in incorporating tactical asset allocation within strategic boundaries is to define clear parameters for these adjustments. This involves setting limits on how much the allocation to any given asset class can deviate from its target in the strategic asset allocation plan.

Our boundaries are as follows:

• Single Asset Class: ±5% from benchmark

• Aggregate Equities (US Lcap, US Scap, Intl, Emerging): ±10% from benchmark

• Aggregate Bonds (US Bonds, Intl Bonds, EM Bonds): ± 10% from benchmark

• Cash: ±5% from benchmark

For instance, if equities make up 60% of your strategic allocation, you might allow for a tactical deviation of up to 10% in either direction, depending on market conditions.

This ensures that while you are making adjustments in response to short-term market movements, your portfolio remains aligned with your long-term investment goals and risk tolerance.

Current Asset Allocation Targets

We intend to re-balance our three asset allocation mixes to the suggested target allocations by the end of March.

Given our views on the attractiveness of the key asset classes, our target allocations are as follows:

Asset Allocation Performance Review

High-Level Observations:

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse but the trend is up. Over the last three years, the GF Low-Risk strategy is only up 2% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.8%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF High-Risk strategy is up 4% on an annualized pre-cost basis over the last three years. over the last 5 years, the strategy is up a respectable 7.6%.

• The performance of all three asset allocation strategies over the last year has been remarkable and has significantly boosted the 5 year numbers.

• Equities plus Commodities have been the drivers of this performance.

Weekly Performance Attribution

Source: iShares, as of 3/19/2024

A Bit of Humor Never Hurts

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