Asset Rotation and Stock Picking

What I’ve been looking at over the past two weeks, asset rotation or tactical asset allocation, is a strategy that an investor could use to outperform the market average. This raises the question of whether or not asset rotation could be combined with fundamental (value-driven) investment research.

For a number of reasons, it doesn’t make sense to me. In my review of the research, two possibilities were presented. Either an investor could incorporate both momentum and value data into their screen or they could combine a momentum strategy and a value strategy into a single portfolio for improved diversification. One interesting example is Mebane Faber, who researched applying a momentum screen to market sectors rather than asset classes. That strategy appears to outperform the market.

In theory, it would be possible to use the momentum strategy to select the preferred sector, then rather than buying an ETF, selecting representative stocks that present the most attractive valuation. Such a strategy would require a great deal of research. Multiply that by relatively high turnover and it would probably not be sustainable over time.

It would make more sense to split an investment account in two, one using each strategy. According to the research, the two strategies zig and zag separately, so this would reduce volatility. But it also works well in another way. It has occurred to me that investors really only have one of two goals: capital appreciation or current income. Those two goals coincide very closely to two styles of investing: momentum or income (from interest or dividends, generally). Some investors may have those two goals at the same time, such as a client who has retired with more than enough assets to meet their income needs . They would probably want to invest enough of their investments to produce adequate current income (market value for this portion becoming irrelevant) and want to invest the remainder for capital appreciation (not needing the income from this portion). This would provide two ways of mitigating the pain of a market crash: either the income is still coming in, or rotating to an asset class that has better momentum, away from stocks, to avoid the worst of a downturn.

The asset rotation strategy seems entirely incompatible with my strategy of investing for high income, which is currently working well, given my need for income and the prevailing low interest rates. For that reason, I’ll find a portion of my investment portfolio that isn’t currently producing income and move it into my tax-sheltered RRSP. I don’t want to take income from the RRSP yet and then the transaction won’t trigger tax liabilities. I will commit it to asset rotation, which I expect to do at least as well as the stock market during the current bull, and to vastly outperform during any future market crash.

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