Tactical Investing in a VUCA Equity Market

 [Investment management can be said to share an operating environment that the U.S. military has characterized as VUCA – volatility, uncertainty, complexity, ambiguity – which acknowledges the difficulties in analyzing, responding to, planning for situations, and making hard decisions. There are no simple, straight-forward answers. Many dimensions of risk and opportunity have to be calibrated into a strategic decision or specific course of action.

With all the confusion and disruptions in the markets today, it may be a good time to take a harder look at tactical investing methodologies which were designed to grapple with this specific challenge head-on. We decided to re-visit the Leuthold Group – a Minneapolis-based market research and early pioneering tactical money management firm that offers a family of mutual funds, SMAs, and ETFs.

In our previous interview with the Leuthold Group – “How Do You Read and Diagnose the Health of the Market” – we focused our discussion on their macro research analysis process and the creation of their Major Trend Index which provides a disciplined tool to gauge the overall health of the market and determine the appropriate equity exposure for their investment portfolios.

In our current article, we dive deeper into the next steps of their tactical quantitative approach of deciding where to deploy investment capital through their Leuthold industry group rotation strategy that focuses on targeting specific industry groups rather than sectors.

We reached out to Greg Swenson, Senior Analyst and co-Portfolio Manager of a number of funds, including the Leuthold Select Industries (NYSE: LST), the Leuthold Core ETF (NYSE: LCR), and Leuthold Grizzly Short Fund (GRZZX), to ask him to share the firm’s tactical investment methodology and perspectives on asset allocation and rotation strategies in volatile, uncertain, complex, and ambiguous equity markets.]

Hortz: Why does your tactical investment selection process and asset allocation rotation decisions focus on industry groups versus a more traditional investment sectors approach?

Swenson: Whether it is a tactical sector rotation portfolio or a fundamental bottom-up stock selection portfolio, more attention has traditionally been paid to broad sectors than industry groups. We know sectors matter, but there is a wealth of information to extract by going deeper, focusing on the industries that make up those sectors. While there are 11 broad sectors, there are currently 163 sub-industries – the most granular level of the Global Industry Classification Standard (GICS) structure. There are tremendous differences among sub-industries within the same sector, whether we are looking at them from a fundamental, macro, or volatility perspective.

Sectors have also become increasingly tied to a handful of mega-cap stocks. Due to the rise of the Mag-7, there are several sectors where two or three stocks account for more than 50% of the market cap. In certain instances, allocating to specific sectors has basically turned into making a call on a few individual stocks. This has caused correlations between sub-industries and their sectors to fall to levels not seen since the Tech Bubble (chart below), presenting a tremendous opportunity for industry selection within sectors.

Hortz: Can you give us a brief example of a sector versus an industry comparison to further illustrate your points?

Swenson: Take a sector like Industrials where there are 24 individual sub-industries with a wide range of fundamentals and characteristics. There are pro-cyclical industries that have betas over 1.5 like Airlines or Construction Machinery, but also more defensive industries with betas closer to 0.5 like Environmental Services (Trash) or Research & Consulting Services. Just last year (2024) there was a 63% performance gap between the best performing Industrial (Airlines) and the worst performing (Air Freight & Logistics).

Being able to analyze and target the wider opportunity set that sub-industries offer allows for more diversification from a style and market exposure standpoint. We recently released a research piece that goes into more detail on how the different levels of GICS groupings differ from one another.

Hortz: What processes and tools have you developed to guide you in selecting industry investments through all the disruptions and noise in the markets? How do they consider all the market, economic variables, and factors into your decision-making process?

Swenson: We use a quantitative framework called the Group Selection Scores (GS Scores) to help us with targeted industry selection. That framework has been in place at The Leuthold Group for just over 30 years now – a lengthy history for live model performance. We evaluate roughly 120 industry groups (a hybrid of levels 3 and 4 of the S&P GICS structure) made up of the largest 3,000 stocks that trade on U.S. exchanges (including some ADR’s).

While some sector rotation strategies choose to focus on either price action or macro data, we incorporate both, along with valuations and fundamental metrics, to get a well-rounded profile of every industry in our universe.

The GS Scores have generated positive performance over both the long term and, more recently, successfully navigating a variety of market conditions in the process, as the chart below shows. The main drivers of outperformance from the GS Scores are 1) a high hit rate or batting average – getting more groups right than wrong, 2) industry avoidance – the ability to completely avoid parts of the market that are underperforming, 3) identifying long secular winners.

Hortz: What is an example of an industry the scores pointed to that ended up being a big winner?

Swenson: We owned the Semiconductor Equipment industry for over 8 years, from mid-2016 to late 2024, during which the group generated annualized returns of 28% versus 9% for the average industry group and 15% for the S&P 500 over the same period. The group worked out so well because we held it during its evolution from a highly cyclical, boom-bust industry to the more stable, persistent growth and profitable industry that is today. While these companies were always key suppliers to chip companies, they are now viewed as an essential part of the global supply chain.

The GS Scores were invaluable in not only identifying the industry early on but also helping us hold it through volatility during which we otherwise would have sold it. Ultimately that is one of the key features of the process – giving us conviction to make portfolio decisions that are uncomfortable and that we probably would not do if left to our own judgment.

Hortz: On another area of your investment methodology, what role does equity hedging play?

Swenson: We have a fully invested, 100% short approach called the Grizzly strategy. That strategy is offered as a stand-alone mutual fund and is also the method we use to hedge within our own tactical accounts when we want to lower equity exposure. Keeping the strategy fully invested is a key feature because investors know how much exposure they are taking off when they invest. It is also a more tax efficient way to bring exposure down versus selling long holdings and realizing capital gains.

While we use a quantitative approach here as well, unlike on the long side where we are looking for broad themes, our shorts are much more stock specific – looking for securities that are overvalued and, for any number of reasons, will likely be rerated lower at some point in the near future. 

A short only product can be challenging to manage during extended bull markets like we are currently in, but when sentiment shifts, it is an invaluable option to have in our toolkit – both for us and our clients.

Hortz: How does Leuthold work with institutional investors and financial advisors?

Swenson: We offer all of our strategies via separately managed accounts and publicly available vehicles, including mutual funds and ETFs. In January, the Select Industries mutual fund transitioned to an active ETF which we are very excited about. The ETF wrapper is particularly suitable for an active equity approach like this as it improves on fees, transparency, and is much more tax efficient.

We also produce market research for other institutional money managers that focuses on macroeconomic, top-down market, sector, and industry views. Our asset management clients find this research particularly helpful in adding color to conversations with their own clients as well.

As a boutique money manager, we pride ourselves on our accessibility and transparency with our investors – we truly view the relationship as a partnership.

This article was originally published here and is republished on Wealthtender with permission.

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