A Tactical Approach to Asset Allocation

Charlie Toole:

Hello and welcome to another The Adviser You Can Talk To Podcast. I’m Charlie Toole, a portfolio manager at Adviser Investments, and today I’m joined by my colleague, Josh Jurbala, who’s our quantitative investment manager and runs our tactical strategies. Josh, welcome to the podcast.

Josh Jurbala:

Hey, Charlie. Good to be here.

Charlie Toole:

Today is the third installment in a series of podcasts that we’ve been doing on tactical investing and Josh, you and Jeff DeMaso talked in the first two episodes about our philosophy in how we approach and think about tactical investing. If the listeners want to hit pause on this podcast and go check out those first two, they certainly can, but this conversation will stand on its own because it’s going to be about a specific tactical strategy and that’s our Tactical Multi-Asset Income strategy. We’ll get into the details but first, let me just sort of from a high level give a brief elevator pitch on the strategy.

Charlie Toole:

There’s been a lot of talk about low interest rates and inflation, and those are really the main things that are in the headlines today. That’s caused a lot of angst for investors. How does a portfolio manager position their portfolio for the unknown road ahead? Well, a multi-asset strategy is a way to further diversify the portfolio and add assets that can produce more income and possibly more growth. We know that venturing from high-quality stocks and bonds into these alternative assets with higher yields sometimes comes with higher risk. So we provide, or we use, a tactical approach to try to manage that risk. Josh, does that sound like a good summary of the strategy that we’re going to talk about today?

Josh Jurbala:

Yeah, I think you covered it well.

Charlie Toole:

Okay. Let’s start with the basics. When I say multi-asset, what does that mean? Or why should investors consider that for their portfolio?

Josh Jurbala:

Sure. So as you alluded to, a multi-asset means a strategy that just holds a wider variety of asset classes, not just your typical stocks and bonds. It might hold riskier segments of those groups like high yield bonds or real estate stocks, for example. Multi-asset strategies also venture into alternatives like gold, currencies, broader commodities. Why are we talking about it? It’s a unique time, I would say. Even with the rise in rates earlier this year, bonds are still yielding next to nothing. Equity valuations are pretty stretched.

The two traditional asset classes offer potentially lower returns going forward and that worry combined with the worry of inflation, as you said, just has investors searching for alternatives to high quality stocks and bonds. Their goal is to generate higher income and outpace inflation, but that can send them into the riskier parts of the market. The main point is that a multi-asset portfolio can help you position for different market environments just by broadening your opportunity set and allowing you to invest in a more diversified set of exposures.

Charlie Toole:

Good. I think in your description, you use to the words, “It’s a unique time.”

Josh Jurbala:

Yeah.

Charlie Toole:

We’ve been hearing a lot from clients that are worried about rising yields and worried about inflation. Maybe just a brief summary about what the current environment is would be a good backdrop for our discussion.

Josh Jurbala:

Yeah. Good point. Rates did rise earlier this year, but they seem to have topped out below 2%, hit our a high of around 1.75% in March and now back below one about 1.6%. That means investing in a 10-year Treasury right now you can expect about a 1.6% annualized return over the next decade if you hold until maturity. That’s considered risk-free, but if you consider inflation, just even averages 2%, that means a negative real return. That’s just not good news, especially for someone nearing or in retirement who’s relying on that steady stream of pretty safe fixed income, holding those safer investments like a 10-year Treasury. That dilemma has just driven investors, as we said, into riskier investments. I think that just kind of sums up the problem.

Charlie Toole:

That’s a great summary. I think inflation one of the, well, you’ve covered one of the reasons why inflation is such a worry for investors because it eats away at those returns. You mentioned inflation running higher than your bond yield, it’s going to eat away at your return. The other is that as inflation rises, so do bond yields and when bond yields rise, prices drop.

Josh Jurbala:

Exactly.

Charlie Toole:

You do get that benefit of higher yields when you reinvest the income, but you’re also getting the volatility of prices as those yields rise. That’s something that we’ve seen in the last three to six months.

Josh Jurbala:

Yeah, exactly. Add that risk to the risk in stocks. As rates rise, stocks have the potential to sell off because rising bond yields set the return bar higher for stocks since investors can now get higher return and safer bond options. Investors begin to sell stocks and move back into bonds and this can be especially painful. Stocks will sell off, especially after we’ve had such low rates for this long, and valuations are this high, there’s potentially some air coming out of the markets. We have seen that in the first few months of the year here too. Growth stocks are especially prone to that sell-off as we’ve seen more recently. Growth stocks just have uncertain cash flows and that those cash flows are discounted further into the future at those low rates. We know that investors are overweight growth given its extreme outperformance over the past year and the past decade, even. That’s just a little bit more expansion on that dilemma we were talking about that investors are facing.

Josh Jurbala:

We do know there are ways to mitigate those risks. For example, investing in higher-quality dividend paying stocks, as opposed to growth. Dividend-payers offer potentially better fundamentals to fall back on, pay reliable dividends that you can rely on year to year. We hold dividend stocks in our portfolio for that reason, our core portfolios. We also include them in an equity sleeve for our tactical multi-asset strategy as well. I know I don’t have to tell you, Charlie, the potential benefits of dividend stocks, you manage the Dividend Income portfolio, so you’re used to talking about these.

Charlie Toole:

I could go on and on about dividend-growth stocks, but I won’t, I’ll spare the listeners. We’re here to talk about multi-asset income. One of the things in addition to traditional high-quality stocks and bonds, there are also some riskier options out there. We’ve sort of alluded to this, but I think of high-yield bonds as one of those primary riskier assets that investors are gravitating towards in this low-interest-rate environment.

Josh Jurbala:

Yeah, exactly. Higher-yield bonds do offer higher relative yields so about a 3% spread over treasuries right now, but those spreads have tightened a lot. There’s less potential upside of these levels from price increases. You just have to rely on high yield for consistent income and you do take on the risk that prices sell off. That’s why we use tactical income to target exposure to those riskier bonds. Me and Jeff talked about that in a recent podcast, which I’m sure listeners can catch on our site. We do a deeper dive into just high-yield bonds. I think that’s pretty much why we use tactical is to gain access to riskier segments like high-yield.

Charlie Toole:

We’ve talked about some of the potential problems out there in the current environment and dividend-growth stocks and tactical high-yield bonds are certainly two ways to address it. But what are the benefits of a multi-asset strategy or how can a multi-asset strategy help investors today?

Josh Jurbala:

It just expands your opportunity set with more diversified exposures as we started talking about. You could still hold traditional high quality bonds and stocks, but you also hold exposure to income-focused assets like real estate or mortgage-backed securities, for example. There are also equity-like assets like preferred stocks and convertible bonds, which can deliver higher income, but do come with greater risks. Then you could also expand internationally into emerging market bonds, which offer higher yields, but also come with pretty extreme risks.

Charlie Toole:

Okay. Are all the different alternatives income producing, or are there some non-income producing assets in this as well?

Josh Jurbala:

That’s a good question. No, they’re not all income producing. We do hold some diversifying assets or uncorrelated assets, which tend to zig when stocks and bonds zag. These are commodities or gold, precious metals. They don’t produce income, but they can grow in price at times when stocks and bonds underperform. For instance, gold is typically seen as a safe haven and possible inflation hedge. It’s uncorrelated with stocks over certain periods. We see that worth holding in our commodities and currency sleeve of our Multi-Asset portfolio. Then there are also broader commodities, which are useful as a tactical option in times when economic growth is accelerating and inflation is heating up, as we think it is now. We’ve seen that trend recently. Commodities are up over 25% this year, while the S&P is up just about 12% and the Agg’s down around 3%. That just shows the potential benefits of commodities although we do see risks in holding it for the long term.

Charlie Toole:

That’s a good point on the risks for the long term, because I think your main point here in adding these other asset classes or these alternatives is that you get the benefit of diversification and the diversification of the lower correlations, but the diversification of income as well. If you’re getting that diversification benefit, why do we need the tactical approach?

Josh Jurbala:

Good question. The simple answer is each of those assets comes with their own risks. We use tactical to manage those risks. Gold might be uncorrelated to stocks, but it’s had drawdowns of almost 50% in the past 30 years and it can underperform for long periods. Commodities, as I mentioned, could be extremely volatile so we don’t recommend a holding them for the long term. The broad index has fallen over 80%, which is just crazy to think about. Even at a small weight, that can hurt and long periods of underperformance can just be a heavy drag on your portfolio. We use tactical to minimize those risks, that extreme draw down risk, and we try and hold while prices trend and then sell before the drawdowns become extreme. I guess that key point is that we use tactical to gain access to those risky assets that can still be beneficial to hold in certain environments, but can be too risky for certain investors, especially retirees or someone withdrawing income to buy-and-hold over long periods.

Josh Jurbala:

That’s not to say that we’ll be adding Bitcoin to the portfolio any time soon. Some assets are just too volatile. We avoid direct exposure to energy for the similar reason, but we do include, as I mentioned, broad commodities just because they specifically trend for economic reasons at certain times. Another point I would just add is that we don’t want to over diversify. We don’t hold all assets all the time in our tactical strategies, we use a trend following momentum approach just to target specific areas that are outperforming and rotate in and out of different holdings based on the prevailing trends. That’s just a key differentiator between our tactical and our kind of core portfolios.

Charlie Toole:

Good. An investor’s getting the benefit of the diversification. They’re also getting the benefit of the tactical approach, and I think really the third benefit or the third way you’re managing the risk—and now we’re going to get into a little bit into the weeds of the strategy—is you’re also preventing (or not preventing, but I guess limiting) the amount that you have in each asset class.

Let’s get into the specifics of the strategy. How are you building the portfolios with all these different asset classes?

Josh Jurbala:

Sure. At a high level, it holds eight sleeves, each focused on an asset class that we’ve discussed so far. For example, there’s an investment-grade sleeve, a high-yield sleeve, an equity-income sleeve and a commodity sleeve. Each of these has multiple options. All ETFs. We use ETFs to gain exposure to each of those asset classes.

Josh Jurbala:

One example is the investment grade sleeve, which can hold traditional high quality bonds like treasuries, high quality corporate bonds, or munis (municipal bonds). Then there’s also an equity sleeve that can hold some dividend-growth stocks or preferred stocks or convertibles. Those sleeve options are all ranked based on trends and total returns. Higher income assets will be held if prices are stable. Each sleeve can also hold cash if no option is trending or if the entire market selling off, just as a defensive buffer. The strategy can hold aggressive exposure, but it’s also relatively defensive and it also trades weekly, but can go to cash any day if markets really sell off.

Charlie Toole:

Okay. We’ve got, as I mentioned, the diversification benefit, you’ve got the eight sleeves, so we’re also capping how much we invest in a particular asset class.

Josh Jurbala:

Yeah.

Charlie Toole:

Then we’ve got the tactical piece. As you mentioned, in extreme markets like March 2020, where you saw bonds and stocks selling off, the strategy can also take that final defensive measure of moving to cash.

Josh Jurbala:

Yeah, exactly. The way I would put it is there are two pieces of the risk management that we use here. One is diversification and other is cash. Diversification’s the main tool, it diversifies across all the assets it holds over time. For example, if the strategy is holding gold and the price suddenly drops, it can re-rank those sleeve options and trade into an asset like broad commodities, which might be trending. But if no options are trending or the entire market’s selling off the sleeve might just hold cash. That dual tails risk, we can manage using diversification and cash.

Charlie Toole:

Okay. Without giving away the “secret sauce,” how are these trade signals determined?

Josh Jurbala:

Good question. Trade signals are based on price momentum. That just means that aims to hold assets that are in a positive trend with prices steadily rising or it’ll hold assets where prices are just stable but delivering higher income. For instance, as we’ve talked about with high-yield. As long as prices are steady, we’ll just keep clipping that coupon, so the high-yield sleeve is currently holding high-yield. The key point is that we don’t want to use economic indicators to try and forecast the future market movements. We value, basically, preparation over prediction. We want to be prepared for any market environment, but we don’t necessarily need to predict what the next environment will be. We hold all those options in the portfolio so we can pick and choose based on price trends. We believe the best signal is already reflected in the price so we don’t need to predict anything using economic indicators. That’s a pretty straightforward approach.

We always say we like to “keep tactical practical.” We think that’s the best way to do it.

Charlie Toole:

Great. That’s interesting and I think it’s a great overview and for listeners that want to take a deeper dive into the strategy. They can contact us and we’ll be happy to set up a call with them to review or even go deeper into how the strategy works.

Charlie Toole:

Before we wrap up, I just wanted to ask one last question. Obviously the last year-and-a-half has been as unique a time in investing as there ever has been dealing with the COVID-19 pandemic. How did the strategy behave? Not only through the pandemic, but through the recovery?

Josh Jurbala:

Yeah, so it’s been a crazy past year. The strategy did go partly to cash last March, and it went to a higher-quality bonds just for safety, but then it did kind of position into more aggressive exposures early on, and went into commodities, just kind of following that inflation trade. It held gold for a good period of time and high yield, which sprang back pretty quickly around April or so. Since then, it’s held a lot of those exposures pretty steady, but then once we talked about bonds selling off earlier this year, it did start selling those longer-duration assets and moving into more diversified exposures. It still continues to hold high-yield bonds, it holds commodities, it just moved into gold recently just on the basis of that inflation trade. It really has shown the diversification that we’ve talked about.

Charlie Toole:

Great. Just to wrap up our discussion, Josh, investors don’t have to rely on just traditional stocks and bonds for income. The Multi-Asset Income strategy can take advantage of diversification and invest in alternative assets for higher income and lower correlation. Then you also apply a tactical framework to manage risk and try to minimize drawdowns and this strategy can be a great compliment to those traditional stock and bond portfolios.

Charlie Toole:

Josh, thank you for the time today. It was great catching up on this strategy. As we mentioned, there are two others in our tactical series, two other podcasts that listeners can listen to. Please check those out as well.

Josh Jurbala:

Definitely. Great. Thanks, Charlie. This has been great.

Charlie Toole:

This has been Charlie Toole and Josh Jurbala from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts, and your feedback is always welcome. If you have any questions or topics that you’d like us to explore, please email us at info@adviserinvestments.com. Before closing, I’d like to thank Ashlyn Melvin. She is the silent voice on this podcast that does all the work in the background. Thank you for the hard work, Ashlyn. And thank you for listening everyone.