Last week in Part I, we began a discussion of why we use a tactical sleeve in our management of client portfolios. We discussed bull and bear markets and the supply/demand factors that affect asset prices. Today we will wrap up with Part II. So to continue:
Many investors equate investing to buying stocks. But over the last ten years, access to other asset classes (traditionally only available to large institutional investors) has become available to a much wider segment of the population. Broadening the places for investment from just U.S. stocks to other asset classes like international stocks, commodities, fixed income and even cash equivalents gives you greater flexibility in your investments when U.S. equities are not in favor. Asset classes tend to rotate in and out of season just like the produce in the supermarket. Over the last twenty years, no one asset class has held the top spot for performance in each and every year. Sometimes U.S. equities were at the top, sometimes they were at the bottom. Sometimes commodities found their way to the top in terms of performance, while in other years it was fixed income or cash equivalents. Just as a chef will seasonally adjust his menu offerings based upon the freshest produce available, investors should be willing to shift their portfolio focus based upon what asset class is in season.
Dynamic Asset Level Investing (DALI)
Our analysis evaluates the supply and demand forces of particular asset classes and ranks the asset classes from strongest to weakest based upon relative strength (RS). We believe asset classes can be ranked similarly to the way one might rank sports teams. If you think about your favorite sport, teams are ranked based upon how well they perform against their opponents. The more games, matches or races won, the higher the team will be ranked. We believe something similar can be done in the investment markets. Each day, a “game” is played; it consists of comparing the daily performance of one asset class to another to determine which asset classes are the strongest or weakest on a RS basis.
The ranking process is comprised of the following 3 steps given the name Dynamic Asset Level Investing (or DALI for short):
- A roster is established for each asset class. For instance, in the international space, all areas of the world are represented, from Europe to Latin America to Canada to Australia and Asia-Pacific. The process of determining the roster is essential so that no one segment within an asset class has too great an influence.
- A relative strength calculation is compiled for each member of the roster versus every other member of the evaluation set. In essence, a very large arm wrestling tournament is held. After all individual calculations are computed and charted on a Point and Figure basis, each member now has its number of relative strength “wins.”
- The total number of “wins” for each individual member of the asset class is added together to get a composite score for the entire asset class. The asset classes are then ranked from 1 to 5. The asset classes ranked are as follows: Domestic Equities, International Equities, Commodities, Fixed Income, and Cash Equivalents.
Each day, thousands of calculations are done to support the DALI process and determine which asset classes have emerged as the leaders according to this methodology. As the asset classes fluctuate in strength, emphasized asset classes in DALI will also change reflecting current market trends.
Implementation: Tactical Asset Allocation
Asset Allocation is broadly defined as an investment strategy which assigns specific percentages of a portfolio to the different asset types discussed earlier. The portfolio is then periodically rebalanced to the target percentages. The theory behind asset allocation is that by spreading exposure across several asset classes, risk can be reduced in the overall portfolio. A tactical approach to asset allocation is grounded in the premise of similarly having exposure to multiple asset classes; but, the tactical part of the strategy is to use concepts such as DALI to determine the weighting of each asset class. The weighting of the asset classes will not stay the same over time; the weightings will fluctuate depending on trends in the various markets. Recall that DALI is designed to look at five asset classes and then determine which should be emphasized based upon a relative strength ranking system. We believe this strategy provides a systematic and disciplined way of overweighting asset classes when they are in favor on a relative strength basis, and it also provides a way of putting cash alternatives into the mix when there is no better place to be.
The relative strength strategy does not stop with just determining the strongest asset class. The next step is to use the relative strength methodology to determine which are the strongest areas within the emphasized asset class. There can be a significant benefit in skewing the portfolio toward those sectors performing the best, provided you don’t jump in at the top. Sometimes the domestic equity space will be overweighted in energy, other times it might be technology, and other times it might be healthcare. We believe the underlying methodology to determine this is the relative strength ranking system whereby we compare sectors to each other to determine those sectors demonstrating the greatest relative strength.
We believe it is best to utilize fundamental analysis of the markets and investment alternatives overlaid with a tactical sleeve to help our clients improve their risk-adjusted returns. After all, people want to be financially secure, achieve their goals and dreams, and not worry. Our purpose is to help them.
As always, please pass these blog posts along to those who you think would benefit.
Until next time, Cheers!
Investment in securities does not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, may be worth more or less than originally invested. No system or financial planning strategy can guarantee future results.
Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification.