[There has been a growing trend of reassessing and moving towards a more updated, post-modern portfolio theory (MPT) risk management and portfolio construction process. Traditional MPT portfolio diversification and risk management strategies historically divided portfolio holdings amongst core asset classes such as U.S. stocks, foreign stocks, emerging markets, bonds, gold, commodities and cash. When subsequent major market corrections ensued with less than stellar results for MPT—especially when needed most— that resulted in further diversification efforts with more portfolio parameters and, in some cases, adding a more dynamic, tactical overlay.

This evolution has been inexorably continuing and has led us now into modernizing MPT by further diversifying portfolios across more asset classes, multiple investing methodologies, multiple portfolio strategies, multiple investing time frames and multiple managers, as well as a further evolution of tactical strategies to what some are terming “tactical 2.0.”

To explore this further, the Institute was recently introduced to Drew Horter, president and CEO of Tactical Fund Advisors (TFA) and David D. Moenning, a TFA subadvisor—a growing Cincinnati-based fund group providing risk-managed, multi-strategy mutual funds designed to dynamically adapt to changing market environments. In our discussion, we wanted to explore their investment philosophy and process which they describe as a modernized approach to tactical investing, diversification and portfolio design.]

Bill Hortz: Why do you believe that a tactical approach to investment management is superior to a passive, buy-and-hold strategy?
Drew Horter: From our perspective, the answer is simple. We believe that if given a choice, few investors would intentionally remain fully invested in stocks during bear market cycles. Ask yourself: As an investor, do you really want to just sit there and take it the next time the stock market declines -20%, -30%, -40% or more?

Remember, the mathematics of loss are brutal. For example, a 31% decline (which according to Ned Davis Research, is the mean decline of the bear markets seen since the early 1900’s) requires a gain of more than 44% to break even. And if you lose 50% during a bear market, you will need to double your money to get back to where you started!

So, our thinking is, why not at least try to “lose less” the next time the bears come to call at the corner of Broad and Wall? The bottom line is we believe this is what tactical risk management is all about.

And speaking about trying, passive investors make no effort whatsoever to add alpha to their portfolios. Much like a sailboat, buy-and-holders simply set their portfolio allocation sails and let the market winds carry the portfolio where they may. On the other hand, tactical investors don’t just accept what the market provides, they actively manage their portfolios and adapt to changing environments. In short, a tactical manager seeks to create alpha and manage risk, while passive investors do neither.

The overarching goal of the tactical, risk-managed approach that TFA espouses is to participate in bull market gains while striving to preserve as much capital as possible during those inevitable negative market cycles.

Hortz: In going beyond classical Modern Portfolio Theory (MPT), what do you consider to be the new state-of-the- art diversification techniques needed in today’s portfolios?
David D. Moenning: Traditional MPT portfolios diversify by asset class and geographic region. This was a good idea back in the 1960’s, when MPT originated. But that was before computers. Before ETFs. Before trading apps on cell phones. And definitely before high-speed algorithmic trading.

Today, markets move at the speed of light. And when a crisis occurs, diversification by country, region, or even asset type has little bearing. No, during difficult times, we believe there are really only two asset classes: government bonds—which go up during these tough times—and everything else, which tends to act like the U.S. Stock market.

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