ETF Investing and Tactical Asset Allocation

With their low cost, flexible trading features and degree of diversification, exchange-traded funds (ETFs) have become increasingly popular with all types of investors in recent years. While some investors buy ETFs as the foundation of a strategic portfolio, other investors use ETFs tactically to execute on their shorter-term views on sectors, interest rates and the markets in general. Tactical investing isn't for everyone (there are risks and additional costs involved), but if it's an approach that appeals to you, ETFs might be a good way to put it into action.

Strategic vs. Tactical Asset Allocation



What is a strategic asset allocation?

Almost every investor uses strategic asset allocation, whether they know the term or not. Your strategic asset allocation is the default mix of assets that you intend to hold to help you reach your long-term goals.

This could be, for instance, 30% U.S. stocks, 15% international stocks, 40% bonds and 15% cash investments, or it could be tilted more heavily toward stocks, or include assets like commodities or real estate. In other words, it's the "big picture" mixture of investments in your portfolio.

What is a tactical asset allocation?

Tactical asset allocation takes advantage of shorter-term views of the markets. If, for instance, you believe German companies are especially attractive investments for the next year or so and you put some of your money into German stocks, that's tactical asset allocation.

The same can be said of rearranging your mix of bonds to take advantage of what you expect to happen to interest rates. Or if you move money in your portfolio between stocks of big companies and small companies based on your views of the current market. Tactical asset allocation isn’t day trading—it’s temporarily changing your mix of investments based on what you expect to happen over the next three months to a year.

How does tactical investing work?

If you're going to invest tactically, you need a source for your tactical ideas. After all, you're not going to just randomly decide that a certain sector of the economy is bound to perform well—or poorly. Clearly, this is the most difficult part of the process to get right. It's a rare investor who can consistently do well by repositioning their portfolio to take advantage of shorter-term market movements.

So where to find ideas? Some investors rely on their own research—areas of the world or economy where they have personal expertise or experience, for instance. Or they explore areas that look attractive based on their own number crunching. Others turn to financial advisors or investment publications for investment ideas.

Why use ETFs for your tactical asset allocation?

Once you have a firm idea of what part of the market you think will do well, you need to figure out how to implement it. ETFs are one way to do this.

It's worth noting that there are ways to trade a tactical view other than using ETFs. You could, for instance, buy some individual stocks or bonds in the part of the market that you think will do well. The problem here is a lack of diversification. If you buy just one stock in the sector you expect to perform well, you run the risk of being right about the sector but unlucky with the particular stock. Maybe you choose the one company in the sector whose CEO unexpectedly retires, or where accounting problems are uncovered.

And if you decide to address the diversification issue by buying several different individual company stocks, commission costs can add up quickly. Using an ETF can be a more cost-efficient way to spread that risk out among lots of different companies, reducing the risk that any one specific company will hurt your returns too much.

Another way you might implement your idea would be to find mutual funds that match your market view. This option might be especially attractive if you use mutual funds with no transaction fees, giving them a cost advantage over ETFs, which generally require trading commissions. Keep in mind that all funds have management fees, which can vary widely.

There certainly are mutual funds that focus on particular sectors or pieces of the bond market, but your choices are more limited. ETFs have become popular in part because there are ETFs that cover so many specific niches of the investable markets. If you have an investment idea, the odds are good that an ETF matches that idea. On top of that, ETF operating expenses tend to be lower than those of actively managed mutual funds.

Picking an ETF

The Schwab ETF Select List™ can help you select a low-cost ETF for an investment idea you might have.

The most important factor in your ETF selection is how closely the ETF's investment approach matches your investment view. Read the ETF description and objective, look at the prospectus and examine the top 10 holdings. Make sure that what's inside the ETF matches what you expect to happen in the market. Costs matter, too, as does the liquidity of the ETF (make sure it’s not too lightly traded).

Implementing tactical investing ideas

When it comes to positioning a tactical idea in your portfolio, there are two ways to go about it: tilting within asset classes and using a "play money account."

Tilting within asset classes

Tilting your portfolio within asset classes means that you figure out what investment you expect to perform well, and you come up with the money to put that idea into action by selling something else within the same broad asset class in your existing portfolio. For instance, if you want to buy an industrials sector ETF in the U.S. equities portion of your allocation, you'll sell some existing U.S. stocks or U.S. stock mutual fund shares that you currently own and use the proceeds to buy the ETF. In the future, when you're ready to get out of the ETF, you'll put the money you get from selling the ETF back into the original stocks or mutual funds.

This approach works well if you have a strong strategic asset allocation plan and you don't want to change that overall plan while you make your tactical moves. You'll still have the same overall allocation in U.S. stocks, but more of that money will be in the sector that you expect to perform the best. This also lets you take advantage of the view that a certain part of an asset class is going to do better than the rest of the asset class without having to compare it to other asset classes. The downside is that you might have tax consequences from changing your investments in your "core" portfolio (held in taxable accounts) as you implement your tactical ideas.

Creating a "play money account"

With another approach, the "play money account," you set aside a certain part of your portfolio specifically for tactical ideas. For instance, you might take 5% of your total investments and put that money in an account that's specifically for tactical opportunities. Whenever you come up with a new investment idea, you buy an ETF to take advantage of that idea in this play money account. If there's already another tactical idea in place in that account, you decide whether you want to switch from one to the other or split the money between the two ideas.

With this approach, you leave the rest of your money on track in your long-term strategic asset allocation plan without having to worry about rebalancing effects from changing back and forth between your "core" investments and your tactical ideas. And if your play money is kept to a tax-advantaged account like an IRA, then you won’t have to worry about tax consequences either. The downside is that the play money account is likely to be a mish-mash of unrelated investments, and it doesn't give you the opportunity to make an investment based on the idea that one part of an asset class is going to outperform another part of the same asset class.

Sector ETF trade: Tilting within an asset class Before After US stocks $30,000 $25,000 International stocks $15,000 $15,000 Bonds $40,000 $40,000 Cash $15,000 $15,000 Sector ETF $0 $5,000

Sector ETF trade: "Play money account" Before After US Stocks $28,000 $28,000 International stocks $14,000 $14,000 Bonds $38,000 $38,000 Cash $15,000 15,000 Play money - cash $5,000 $0 Play money - sector ETF $0 $5,000

For illustrative purposes only. Sample portfolio allocations are for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation, including a consideration of tax consequences.

A useful tool for tactical calls

Remember, tactical investing isn't for everyone; some investors prefer to simply set a long-term plan and stick to it, not worrying about short-term market trends. But if you do want to reposition your portfolio tactically, ETFs might be the right tool. Figure out your exact investment idea, find an ETF that puts your idea to work, and decide where you want the tactical investment money to come from. Keep in mind trading costs, commissions, and tax consequences. And be sure to track progress—if you find success elusive, you might need to try new approaches or just go back to focusing on long-term investing.