Tactical asset allocation in a changing market

If you invest with an eye on achieving financial goals, such as a secure retirement, you’ve probably positioned your portfolio using a diversified mix of assets that are designed to perform over the long term – sometimes known as strategic portfolio positioning.

But as the market moves up or down in reaction to various factors, there are a few ways to position your investment assets for potentially better performance. We’ll look at three of these, starting with tactical asset allocation.

Tactical asset allocation

Tactical asset allocation is when an investor fine-tunes their portfolio to take advantage of the fact that capital market results vary in the short term. In today’s market, for example, factors such as inflation, elevated interest rates and improving corporate earnings may be opportunities to implement short-term portfolio adjustments.

As a case in point, investors have seen dramatic changes in the performance of stocks and bonds in the past few years.

“If we look at the first half of 2024 for equities, the story is all about technology stocks,” says Rob Haworth, senior investment strategy director at U.S. Bank. “Recent advancements in artificial intelligence have spurred corporate investment in technology, and stocks in the technology sector benefited the most as a result.” By contrast, he says, “bond markets faced more challenges related to the fact that the Federal Reserve is holding interest rates higher for longer.” Bonds were down modestly year-to-date through June 30, 2024.

There may be opportunities to make minor yet important adjustments to the broader, long-term positions represented in your portfolio. However, you should pursue such short-term tactical moves carefully.

“Specific tactical moves designed to capture a market opportunity within any of those asset classes require investors to be nimble and willing to move quickly in and out of specific positions,” says Haworth.

Opportunities for tactical asset allocation in today’s environment

• Large U.S. stocks: If you invest in equities, you may want to consider a modest tilt toward stocks over bonds. Since a standard index fund features overweight positions in the largest stocks that have already earned outsized returns, you should consider a fund that offers equal-weight exposure to large U.S. stocks. The largest corporations are less sensitive to interest rates, as many of them extended debt maturities and locked in low interest rates for longer terms before the Fed’s interest rate policy change. These companies also tend to have large cash balances, which are currently earning more than 5% interest. “Smaller companies that are more reliant on refinancing debt may see less earnings growth because borrowing expenses are higher,” Haworth says. As a result, small stock performance has lagged that of large-cap stocks.
• Non-government-agency-backed residential mortgage bonds: Non-taxable fixed-income investors may want to consider residential mortgage-backed securities (MBS) not backed by the government, which have strong fundamentals and offer competitive current income. “These securities are particularly attractive given low mortgage loan balances relative to home values and strong incentives for homeowners to remain current on low fixed-rate mortgages they locked in prior to the onset of higher interest rates,” says Haworth.
• Municipal bonds: Tax-aware investors can earn extra potential returns by slightly extending maturity profiles in municipal bond holdings and incorporating a modest allocation to high-yield municipal bonds. While these are on the riskier end of the tax-free bond spectrum, Haworth notes that “high yield municipal bonds tend to have lower default rates than we see in the corporate high-yield market.”
• Insurance-linked securities: Tied to the sale of reinsurance products, these securities can offer highly competitive income streams in the current environment for certain types of investors, particularly within trust portfolios. “As the cost of insurance has gone up, it has resulted in higher yields for investors in insurance-linked securities,” Haworth says.

Dollar-cost averaging

The second situational strategy is dollar-cost averaging. As you accumulate cash in your portfolio through interest, dividends or security or business sales proceeds, investing this cash into asset classes with higher returns, such as equities, is key to meeting your long-term financial goals. However, market volatility might affect your willingness to put lump sums to work in assets that are subject to fluctuation.

Dollar-cost averaging may increase your comfort level with equity investing during volatile times. This strategy involves investing a portion of your cash balance into the target equity portfolio at regular intervals, rather than trying to invest the cash all at once (a practice called lump-sum investing).

“Dollar-cost averaging is a way to get money invested without experiencing the regret that would occur if markets declined immediately after investing a lump sum,” says Haworth. “It elongates your investment period, so you don’t start at just one price point in the market.”

He says investors holding significant cash sums that are intended to meet longer-term goals should consider putting that cash to work in investments like equities.

“Interest rates are likely to come down at some point in the future,” he says, “so investors can’t count on consistently earning the high yields on cash-equivalent vehicles as they are today.”

Portfolio rebalancing

The third situational strategy addresses the fact that asset prices can move in different directions and at different speeds, and these return variations can cause your initial portfolio allocations to drift from your long-term strategy. Rebalancing your portfolio from time to time may therefore be a good idea depending on your investment objectives.

You should pay particular attention to fixed-income (bond) portfolios if your portfolio emphasized high-yielding, short-term debt securities until now.

“Prior to 2023, investors were dealing with interest rates that were still rising, a riskier environment for long-term bond investments,” says Haworth. “We appear to be at a point where short-term interest rates are near a peak. This may be a time for investors to direct cash-oriented investments into other long-term assets.”

“Periodic rebalancing across asset classes with the most significant differences in return and risk, such as stocks and bonds, enhances long-term returns and is effective at managing overall portfolio risk,” notes Haworth. “We first suggest evaluating your relative stock/bond allocation and using recent performance differences to nudge your portfolio back toward its target allocation. Additionally, within an asset class such as mid-cap U.S. stocks, we suggest examining allocations where growth and value style performance has materially diverged.”

Notably, some growth-oriented S&P 500 sectors that were hit hard in 2022, such as communication services and technology, bounced back in 2023 and early 2024. Even in that short time, you might find that some of your portfolio positions got out of balance.

“Make sure you own what you want to own,” says Haworth. “If you have significant positions in assets that have become expensively valued, you may want to reposition those holdings as a way to help manage portfolio risk.”

The table below details annual performance across a variety of asset classes (represented by market indices) for the past five years.

Don’t lose sight of strategic portfolio positioning

Situational strategies such as tactical asset allocation have their place, but the primary driver of your asset mix should be long-term, strategic positions that are designed to be held over time to meet your specific investment objectives.

The core components of a diversified portfolio likely include:

• Equities. Over the long run, stocks have generated strong returns, driving most portfolio gains over most business cycles. While stocks can be volatile and cause portfolio declines from time to time, they remain crucial return-drivers that can help meet your long-term goals. Strong consumer spending, corporate earnings growth, and fiscal stimulus post-Covid have helped support the U.S. economy and equity market performance.
• Fixed income. Over time, high quality bonds provide important portfolio diversification and stable current income. These two features make bonds a key component of diversified portfolios. Bonds provide portfolio diversification due to often having an inverse price relationship with stocks. While stock and bond prices don’t always move in opposite directions, they do act differently over time and provide investors with opportunities to rebalance into stocks after a stock market correction. “Investors trying to preserve a conservative portfolio profile can take a little less risk and invest in fixed-income instruments that are today generating yields in the 5% range,” says Haworth. That’s significantly higher than yields were before 2022, as higher inflation drove the Federal Reserve to raise interest rates, in turn driving bond yields higher.
• Real assets. Real assets represent investments such as real estate, global infrastructure, and commodities and can help balance a portfolio predominantly made up of stocks and bonds. Some real asset categories provide important income and performance diversification during times of elevated or rising inflation.

Maintain a well-positioned portfolio

Tactical adjustments can help you take advantage of specific opportunities in today’s market. You can use dollar-cost averaging to put money to work systematically over time and limit the potential downside risk of a large, lump-sum investment. And rebalancing your portfolio positions can align your asset mix with your goals, time horizon and risk tolerance.

Your wealth management professional can help you blend and select situational strategies to keep your portfolio on target to help meet your long-term investment plans and goals.

The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe and is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Growth Index measures the performance of the mid-cap growth segment of the U.S. equity universe. It includes those Russell Midcap Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Value Index measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI EAFE Value and Growth Indices covers the full range of developed, emerging and All Country MSCI Equity Indices. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. The Dow Jones Equity All REIT Capped Index is designed to measure all equity REITs in the Dow Jones U.S. Total Stock Market Index, as defined by the S&P Dow Jones Indices REIT/RESI Industry Classification Hierarchy, that meet the minimum float market capitalization (FMC) and liquidity thresholds. The FTSE Global Core Infrastructure 50/50 Index and FTSE Developed Core Infrastructure 50/50 Index give participants an industry-defined interpretation of infrastructure and adjust the exposure to certain infrastructure sub-sectors. The constituent weights for these indexes are adjusted as part of the semi-annual review according to three broad industry sectors — 50% Utilities, 30% Transportation including capping of 7.5% for railroads/railways and a 20% mix of other sectors including pipelines, satellites and telecommunication towers. Company weights within each group are adjusted in proportion to their investable market capitalization. The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. The Bloomberg U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed tax-exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The ICE BofAML U.S. High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.