Risk Management:

Tactical Asset Allocation and Sector Rotation

Risk management is a broad term used for any steps taken to protect a portfolio from loss. However, there are different types of loss and different risk management strategies for hedging against each.

Diversification

Diversification, better known as the “don’t put all your eggs in one basket” strategy, helps protect against absolute loss.  For instance, if you own two stocks equally and one of them goes out of business, then your portfolio takes a 50% hit.  If instead, you own 100 stocks equally and one of them goes out of business you would only take a 1% hit in your portfolio.  Mutual funds and ETF’s are a common way to manage the risk of absolute loss through diversification because by design they are comprised of many different securities for a specific investment objective. For example, assume you own an S&P 500 index fund.  In reality, you own a small portion of 500 different companies. If one of those companies were to go out of business and its stock price went to zero, the fund may go down in value but you would be protected from absolute loss.

However, simply diversifying your portfolio does not protect you against market losses. For example, owning an S&P 500 index fund does not protect you against the market for US large company stocks going down as a whole. That risk needs to be managed with different strategies.

Asset Allocation

We want to take the “don’t put all your eggs in one basket” diversification strategy one-step further. If large company US stocks as a class are down 25%, and you own that broad asset class investment, you can expect that asset class in your portfolio to be down around 25%. There is no inherent risk management being applied to this type of market risk simply by owning mutual funds or ETFs. To help offset some asset class risk, investors typically construct a portfolio where a certain percentage of their portfolio is represented by different broad asset classes like stocks, bonds, cash, real estate, etc. This helps manage the risk of having all of your money in one asset class.  If one class is down, it is less likely that all of the classes will be down – you are managing some risk.

Setting the appropriate allocation percentages is a challenge because the optimal allocation at any given time for your specific situation changes based on the current market conditions. For this reason, a static allocation strategy, which commonly is only reviewed on an annual basis, may not allow enough flexibility to effectively manage asset risk at the broad asset class level.

For example, assume you have a static allocation of 60% stocks and 40% bonds and you rebalanced your portfolio on January 1st. However, by the end of the first quarter, stocks were down 20% and bonds were up 5%. Intuitively it makes sense that a better allocation at that point might be 50% stocks and 50% bonds, but your allocation is static so you ride it out.  By the end of the third quarter, stocks are down 30% and bonds are up 10%.  Your original allocation of 60/40 now seems far off given the market conditions.

Tactical Asset Allocation

A tactical asset allocation strategy requires more frequent monitoring and a good bit of unbiased data, but puts in place a set of rules that help to change your allocation mix based on specific metrics in each asset class.  In the example above, during the first quarter it is highly unlikely that stocks dropped 20% in a day or two. It is more likely that the decline happened over several weeks.  A tactical allocation approach may have shifted a percentage of the stocks to bonds or even cash after the first “x”% decline. Fast forward to the third quarter and a tactical allocation strategy may have shifted a sizable percentage of the stocks to bonds before it got to that point – helping to have avoided some of the large loss. The process and metrics are of course more complex than this.  The important concept here is that having an adaptable process can help manage broad asset class risk.

Sector Rotation

Another risk management strategy is sector rotation.  Owning securities representing different sectors within an asset class further diversifies a portfolio and allows the implementation of a sector rotation strategy. It is important to understand that within any broad asset class, there can be a significant difference between the best performing sectors of that class and the worst performers – in good times and in bad. For example, for the large company US stock market asset class, the difference between the worst performing sector and the best performing sector often is more than seventy percent in any given year. That means that although the average for that asset class might have been 10%, there were likely sectors within that class that were up as much as 45% and other down as much as 25%.

From a risk management standpoint, a sector rotation strategy may give you the ability to sell sectors that are showing signs of weakness and buy sectors showing signs of strength. Over the past couple of years for example, the biotechnology and healthcare sectors significantly outperformed the basic materials and precious metals sectors. However, over the past few months, precious metals have outranked both biotechnology and healthcare, while basic materials has stayed near the bottom. Utilizing a sector rotation strategy may have allowed for the rotation away from biotechnology and healthcare while looking for other sectors on the rise.

Risk management is such a broad term it is easy to be confused as to which risk you are managing, or are having managed.  There are many risks in the capital markets that, with some effort and data, may be managed through a variety of strategies. Knowing which strategy to use, the data you will need, and how to implement it is a complex problem. Asking a professional is a good first step in solving it, but be sure you know which risks they are willing to actively manage – often times the answers vary more than people think.

Combining asset allocation strategies, tactical management and sector rotation is not a panacea to market risks.  However, remaining adaptable, process driven and willing and able to make changes when necessary is a great start.

Check out these links on Investopedia for more reading:

Diversification: http://www.investopedia.com/terms/d/diversification.asp

Sector Rotation: http://www.investopedia.com/terms/s/sectorrotation.asp

Tactical Asset Allocation: http://www.investopedia.com/terms/t/tacticalassetallocation.asp