Using Value-Oriented Tactical Rebalancing To Combat High-Correlation Downturns

A promising approach is to combine diversified strategic asset allocation with a value-oriented tactical rebalancing strategy, according to Mark Ricardo, president and chief investment officer of Tiber Creek Investment Management LLC in Alexandria, Va.


Strategic asset allocation with static rebalancing of assets works well during bull markets but failed spectacularly during the recent market dislocation, Ricardo writes in Advisor Perspectives.
There is no need to throw out the baby with the bathwater, though. Strategic asset allocation should remain the baseline method of providing effective portfolio diversification.


In order to protect against losses during severe downturns, investors should add value-oriented tactical rebalancing on top of asset allocation. The idea is to determine the value of each asset class in a diversified portfolio and periodically rebalance with tactical shifts, increasing portfolio weights for undervalued asset classes and decreasing portfolio weights for overvalued asset classes. Limits are imposed so the tactical rebalancing does not nullify the long-term risk profile.


“The potentially lower risk associated with a value-oriented tactical strategy comes from an investor’s ability to limit his or her exposure to overvalued asset classes that are likely to produce negative or below-average long-term returns,” Ricardo writes. Similarly, the potentially higher returns associated with a value-oriented tactical strategy come from an investor’s greater exposure to underpriced asset classes that are likely to produce above-average long-term returns.”


Ricardo adds that this hybrid strategy is best suited for investors with a time horizon of at least seven years because it can take a long time for an asset class to return to its fair value level.
Ricardo also discusses practical ways to measure asset class valuations such as the
Cyclically Adjusted Price-to-Earnings Ratio and the Equity-Q Ratio.
 

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