Tactical Indexing Proves Its Worth

10/30/2012 10:15 am EST

Focus: FUNDS

Building a strategy that takes the emotion out of investing but keeps your assets working when they should and sitting out when things look bad can be very helpful indeed, notes Channing Smith of Capital Advisors.

Gregg Early: I'm here with Channing Smith, managing director of Capital Advisors and co-manager of the Tactical Shares Dynamic Allocation Fund. Channing, I wanted to talk to you a bit about emerging markets, what you're seeing these days considering the developed markets seem to be having so many troubles.

Channing Smith: Well, we've seen a slowdown there as well, Gregg. If you look around the world, we've seen economic indicators slowing for some time, and it's starting to catch up with the earnings.

But what's happening is the asset classes are performing pretty well. I think despite weakening fundamentals, investors need to pay attention to trends in asset markets, and right now the trends are very positive even despite the recent pullback.

If you look at it look at tactically, which Capital Advisors has been doing for a while, you can focus on trends. This system offers lower volatility, it offers lower frequency of negative returns, and helps protect against big downturns.

Gregg Early: What is tactical indexing?

Channing Smith: Tactical indexing is a rule-based methodology. You will see different tactical managers using different types of techniques.

What we use is the moving average, which measures the rolling average of price of the security or market index over a trailing period of days, weeks, or months, and you smooth out the short-term ups and downs in the security's price history. What this metric does for us is reveal the trend of the security more clearly than its daily price.

Here's why investors should pay attention to trend investing. We have studied the monthly returns in the US stock market from 1872 to 2011. We use a simple ten-month moving average, and we ask a simple question, "If the market was at its ten-month moving average, what was the average monthly return going forward...and if it was below that key moving average, what was the average monthly return going forward?"

The results are stunning. In the month after a bullish precondition or above its moving average-and this goes over 140 years-the average monthly return is 1.17%. If you're below that key moving average, the monthly return was 0.28%. So when you're in a positive trend, you're going to see much higher returns.

This is how we have structured our investing; it's to take advantage of this in asset classes. We see the same trend in US developed markets, international markets, commodities, and emerging markets, and so what we have done as our latest iteration, invest globally in all of these asset classes.

Our new fund, the Tactical Shares Dynamic Allocation Fund (TGIFX), which was launched in August, invests in 50 underlying exchange traded funds to get access to the four key sectors: domestic equities, international stocks, emerging markets, and natural resources.

This strategy uses a proprietary moving average based model to systematically adjust its risk exposure to each of the ETFs on a monthly basis. There are no overrides, and it's pretty basic. If the asset class is in a positive trend, investors are going to be invested in that asset class. If the asset class is below its key moving average then it's going to be invested in one- to three-year Treasuries or corporates.

What this has done, if you mix a type of tactical strategy in with overall portfolios, it really reduces the overall risk of that portfolio, because the aim is to reduce drawn-out risk, to reduce the frequency of negative monthly returns, and it seeks a narrower range of outcomes for asset classes. So what it really does is latch on to trends that are working and gets you out of markets or sectors when they're breaking down.

Gregg Early: Are you seeing any secular trends at the moment, or are there some regions that look like they're strengthening relative to others?

Channing Smith: Well, it's interesting. One of the recent changes that we've seen, and we just measured the US sectors recently: tech popped out as obviously in a definable downtrend.

We have seen investment back into Europe, which has been interesting. I really don't know the fundamentals there, but if you think about it, the P/Es are very low there, there is some optimism, so we've seen Europe pretty much get fully invested.

Japan is still weak. The emerging markets are strong, they've seen a comeback, so we're shifting back into a lot of the global asset markets. This was a big change from summer, when we were about 36% invested.

Gregg Early: What percentage are you invested at this point?

Channing Smith: It's about 90% right now, and we check every week. We measure one of these four different asset sectors, and then within that, we'll measure each of the ten to 15 ETFs to determine whether they're in or out.

Right now, we've been in the positive trend. It will be interesting to see as we move into this election what kind of impact that has-depending on which candidate wins-on global markets.

We have a fiscal cliff, we have uncertainty in Europe, but I think the key to this is that investors need to think more globally about this and use a tactical strategy that is global. We might have our issues in developed markets, but a strategy like this gives you exposure to emerging markets and commodities as well.

There are always going to be trends that are working-even if we have a weak US market, which we expect, you're still going to have trends that are working or asset classes that are working and ones that aren't working. This strategy finds the asset classes that are working and invests in them, and it avoids the asset classes that aren't working. It's a very good strategy.

What's interesting when you look at emerging markets is so many people want to throw the emerging markets into just one bucket. Well, you have Turkey and India, and Brazil, and China, and all these different countries that have vastly different structures, different forms of government, different profiles on population to economic growth.

So you really need to take those markets down to another level of granularity and invest in the markets, emerging markets that are working, and our strategy helps you do that. It's going to identify which emerging countries are working and which ones aren't.

Gregg Early: Do you have a particular emerging market that you like right now?

Channing Smith: Well, I think China is always interesting. We don't interfere with the model; it will never be interfered with.

On the surface, when we look at China we think there are some challenges ahead, but the valuation there is very cheap and so that market to us seems fairly attractive at these valuation levels. Considering the population growth, and the trend toward consumerism, it should be a great hold for the next five to ten years.

Recently the strategy got back into China; it had been out of China for some time, just because that asset class had underperformed for quite some time. We've seen somewhat a rebound, so the strategy is back into China right now.

Related Reading:

The Fiscal Cliff and Income Stocks

4 ETFs that Leave Bonds in the Dust

Turn to Hard-Asset ETFs for Now

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