Connect with us

Let's Solve It

Building Diversification by Adding Strategy to Your Portfolio

Published

Building Diversification by Adding Strategy to Your Portfolio

Written by: John Lunt | President, Lunt Capital Management

The principal of diversification drives asset allocation for both institutional and individual investors.  The benefits of diversification do not come from simply adding more investments to an asset allocation, but rather, from adding investments with lower correlations to existing investments within the allocation.   However, a prospective investment may have a higher correlation to existing investments, while still bringing desirable attributes like the potential for lower volatility, downside capture, or upside outperformance.  Ultimately, investors hope to generate more return per unit of risk.  Return requires risk, and we believe that risk is either derived from the asset class (market risk or market beta) or from the manager (strategy risk). 

 In most asset allocations, the equity portion represents the majority of the total risk.  Fixed Income may be used in an effort to lower volatility and to cushion portfolio drawdown.  Today, many investors are concerned about how public policies (particularly monetary policy) have distorted returns for both equities and fixed income.  This has raised concerns about potentially high valuations for equities while at the same time fueling worries about the potential for rising rates and widening credit spreads in fixed income.  In short, investors are worried about “market risk.”  With heightened concerns surrounding market risk, it seems natural for many investors to seek additional ways to diversify portfolios.  In this quest for diversification, investors may ask: what does not necessarily correlate with market risk or market beta?  The answer: active investment decisions or investment strategy. 

Related: A New Take on Portfolio Diversification

Investment strategy is defined as any movement away from market beta within any asset class.  Introducing investment strategy is associated with a unique set of risks.  Adding strategy risk to an investment allocation does not eliminate risk—the risk simply changes form from market risk to strategy risk.  Determining how much market risk to transfer to strategy risk is a critical question when managing a portfolio.  Actively managed funds introduce strategy risk, but many funds are still dominated by market risk.  On the spectrum from market risk to strategy risk, most funds are still closer to market risk (more beta, less strategy).  Some managers keep pushing further towards strategy on this spectrum by introducing rotation across factors, sectors, or countries (balance between beta and strategy).  Strategies that move in or out of an asset class, or that move long or short an asset class, are closer to the strategy risk end of the spectrum (less beta, more strategy).

Many times, advisors present an “either/or” choice to investors.  One side pushes exclusively for market cap-weighted “buy and hold” investing.  The other side demands a portfolio that could move completely “in or out” of a market.  We reject an “either/or” investment world, and instead propose an “and” investing world by combining market risk (maintain asset class exposure) AND strategy risk (introduce varying degrees of active).

Strategies come in all types of shapes and sizes.  Understanding the engine behind the strategy is essential.  Is the strategy qualitative or quantitative?  Is it based on bottom-up fundamentals or top-down macro inputs?  Is it based on momentum or relative value?  What is the time frame associated with the specific strategy? Investors should not move assets from market risk to strategy risk if they are unwilling to allow a strategy to do what it is designed to do—which is look different from the asset class beta.  The amount allocated to strategy within a portfolio should be driven by the tolerance for underperformance in both magnitude and time relative to where the allocation comes from.

Related: Factor in a Smarter Approach to ETFs

ETFs have revolutionized the ability to introduce strategy into portfolios in an efficient, cost effective, and targeted way.  Investors and financial advisors have access to ETF strategists who actively manage portfolios of ETFs in an effort to add value through the tactical management of asset class beta.  Also, investors have increasing opportunities to invest in ETFs that introduce the strategy within the ETF itself.  A prime example is the JP Morgan Diversified Alternatives ETF (Ticker: JPHF).  JPHF not only introduces strategy to a total asset allocation, but also brings diversification by strategy.  This ETF provides the opportunity to access equity long/short, event driven, and macro-based strategies within one ETF. 

Most investment portfolios are dominated by market risk.  We believe a compelling case can be made to take a portion of the market risk within a portfolio and transfer it to strategy risk.  In the continual quest to add diversification, we believe investors should consider adding investment strategy to their portfolios.

Call 1-844-4JPM-ETF or visit www.jpmorganetfs.com to obtain a prospectus. Carefully consider the investment objectives and risks as well as charges and expenses of the ETF before investing. The summary and full prospectuses contain this and other information about the ETF. Read them carefully before investing.

DISCLOSURES
The foregoing is not investment advice or a recommendation or offer to buy or sell any security.  Views expressed are those of the author.  Past performance of an investment is no indication of future performance. © 2015 Lunt Capital Management, Inc. 
Lunt Capital Management, Inc. is not affiliated with JPMorgan Chase & Co. or any of its affiliates.
 
Continue Reading

Trending