Use a Tactical Overlay for Drawdown Protection on Buy & Hold Strategies
Click here to download an 11-page Tactical Overlay White Paper, click on the following link:
Tactical money management
Tactical has been in vogue since 2002 (after the last big stock market crash). We are big fans of tactically managed strategies and have many on our platform. We also know that many advisors prefer to use “buy and hold” or MPT portfolios (which is why we think so many readers will find the white paper interesting).
What is a good definition for tactical money management? Some use the term “active money management.” It’s an investment style where the managers have developed algorithms or indicators that tell them when the stock market is getting risky. When the indicator signals blink red, most of the managers will go to cash or move money to AGG (U.S. Aggregate Bond Index).
What is a tactical overlay?
It’s a signal that is placed on top of a “passive strategy.” When the tactical overlay’s signals kick in because market conditions are getting risky (or the market could already be in the midst of a downturn), you liquidate some or all of your position in the passive/buy/hold strategy and place the money in cash or AGG.
When the tactical overlay’s signal say the storm is over, you then reinvest in the passive/buy/hold strategy. The goal is simple with the overlay. You want to avoid big downturns that even a high quality passive/buy/hold strategy won’t be able to avoid. And of course you are trying to capture a decent amount of the gains when the bounce from the bottom of the downturn takes place.
What investments can take advantage of a tactical overlay?
–Stocks or mutual funds; –Indexes; –Custom portfolios
Does it work? It can, and it can in a spectacular manner.
Let’s assume you are like most and use some form of buy/hold platform for your clients. You decided that you needed something unique to help differentiate yourself from the competition and bring on more new clients each year. So, you decided to offer a tactical overlay to clients.
For our example, we are going to use a 30-stock strategy (click here to learn more). For this summary all you need to know is that the strategy invests in 30 of the 500 SPY stocks at any given time and that they are always invested.
Like the SPY 500, the 30-stock strategy took some big losses in the 2007 crash. The SPY was down over 50% and the 30-stock strategy was down 30.37%. The 30-stock strategy’s CAGR from 2003 – 2011 (a time period that included the ’07 crash) was 27.86% when the SPY was only 6.82%.
So while no client should complain about the return of this strategy, when it went negative 30.37% in the 2007 crash, I’m sure clients were panicking.
Adding the overlay-when you add our custom overlay, how did that affect the drawdown and return of the 30-stock strategy? Let’s look at the chart that was created using the OnPointe Risk Analyzer software.The drawdown was only 13.91% (vs. 30.37% w/out the overlay) and the CAGR went up to 32.81%.
What do you think? Are tactical overlays something that securities licensed advisors should learn about? Again, keep in mind you can add a tactical overlay on an S&P 500 index or the Russell 3000 or just about any portfolio.
Do you think your clients would be interested in adding a tactical overlay to some portion of their portfolio? Our opinion is absolutely they would.