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Risk-managed strategies like the strategy we use to manage the FundX Tactical Upgrader Fund (TACTX) swap some of the growth potential of stocks in exchange for the potential for downside protection. These strategies attempt to deliver growth with substantially less volatility than a fully invested approach. They can use a number of tools to achieve this, including holding cash or fixed income to buffer volatility; short-selling stocks or stock indexes as a hedge; or using options and other forms of derivatives in an attempt to generate income, limit risk exposure and/or seeks to provide downside protection.
We believe there are several key factors that make each of these strategies different from the others: the manager’s process for determining the trade-off between the risk of loss and the risk of lost potential; the selection process for both long and short positions; and the tools used to position the portfolio.
Here’s how our Tactical strategy works:
We use technical analysis and a series of objective models that measure valuations, investor sentiment, monetary conditions, and trend strength to derive expectations about near-term market outcomes (i.e. risk that the market will decline, the upside potential if the market advances).
We attempt to position the portfolio for the most probable near-term outcomes based on these models and analysis. But since market outcomes are often different than expected, we also hold positions that could benefit from the unexpected.
We may use a broad range of tools to increase or reduce the Fund’s stock market exposure. We have the flexibility to hold considerable cash in money market funds and US Treasury Bills. Cash can serve as a hedge but has very limited upside potential. We can also trade both exchange-traded funds (ETFs) and options as often as needed in order to seek a desired level of downside protection and upside participation.
We select a diversified portfolio of funds and ETFs using a process called Upgrading: funds are sorted by risk and ranked monthly by relative performance. We buy highly ranked funds and sell them when they fall in our ranks. (When needed, we may also sell funds in order to take profits and raise cash.) The Upgrading process attempts to respond to changing market conditions. By continually following the Upgrading process, we attempt to align the Fund’s portfolio with current market leadership.
We use options to both raise cash and to put cash to work. Options can also be used to potentially provide downside protection in periods of portfolio transition.
To invest cash, we can purchase ETFs or sell put options that obligate the Fund to buy an ETF below a specified strike price within a specified time frame. Selling put options can generate income while we wait for the ETF’s price to reach a more attractive level. TACTX keeps the income generated from selling the option regardless of whether the ETF goes up or down, but the Fund only buys the ETF if it declines
To raise cash, we can sell an ETF at its current value or sell a call option, which obligates the Fund to sell an ETF for a specified price within a specified period of time. TACTX has collected income regardless of whether the ETF’s price has gone up or down, and only sells the ETF at the specified price.
In an attempt to protect TACTX from market declines, we can purchase put options, which can make money if the market declines below a specified level within a specified time period. These options cost money (the “premium”), and the premium erodes over time. If TACTX holds put options and the market rises, the maximum loss is the premium paid. If TACTX’s ETF portfolio gains more than the cost of the premium, TACTX can increase in value even when the put option expires worthless.
In periods of portfolio transition or heightened risk, we may purchase call options, which increase in value when the market rises. Like put options, call options cost a premium that erodes over time, but purchasing call options gives the Fund the opportunity to participate in the market’s potential gains, while limiting potential losses to the amount paid in call option premiums (which is the amount of the investment).
Since option premium erodes over time, TACTX limits investments in option premium to no more than 5% of the portfolio value and generally holds much less.
Using options is one example of how TACTX’s strategy has changed since the Fund’s 2008 inception. When TACTX was launched in early 2008, there was far less demand for risk-managed investments and the Fund’s initial strategy was biased toward being fully invested. The strategy used models with a long 30-year history that prompted the Fund to stay invested through 2008, generating an unacceptable loss.
In late 2009, we changed TACTX’s strategy and the approach now is balanced between managing risk and pursuing capital appreciation. The current strategy includes using options, which gives us the ability to make more incremental portfolio changes.
Diversification does not assure profit nor protect against loss in a declining market.
Click here for TACTX standardized performance. Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data quoted is current to the most recent month end.
Options and future contracts have the risks of unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates and currency exchange rates. These risks may be greater than risks associated with more traditional investments.