Tactical Asset Allocation: The Flexibility Advantage
Strategic Asset Allocation (SAA) determines long-term exposure to systematic risk factors. That said, the current changes in monetary policy in many developed and emerging countries as well as the stage of the economic cycle warrant tactical considerations.
The tactical overlay strategy should generate added value by temporarily deviating from the weights assigned in the SAA process. Let me explain.
Asset allocation dictates the expected risk and return as well as the cash flow pattern of the portfolio. Empirical analysis demonstrates that asset allocation is the primary driver of variation in returns over time. In “Determinants of portfolio performance,For example, Gary P. Brinson, CFA, L. Randolph Hood, CFA, and Gilbert L. Beebower conclude that asset allocation explains on average about 90% of the variation, while timing and security selection explain the rest. In another study, “Does the asset allocation policy explain 40, 90 or 100% of the performance?Roger G. Ibbotson and Paul D. Kaplan, CFA, focus on the cross-sectional variation in mutual fund returns and find that asset allocation accounts for about 40% of the variation.
The message is clear: asset allocation matters.
But when it comes to the asset allocation process, we need to distinguish SAA from Tactical Asset Allocation (TAA). In SAA, the long-term capital expectations of different asset classes are combined with an investor’s return objectives, risk tolerance and constraints. On this basis, exposures to authorized asset classes are determined. The result is a set of portfolio weights for the asset classes. This is called strategic asset allocation or political portfolio.
The SAA should represent the reward for bearing systematic risk, or risk that cannot be diversified. In other words, the returns are derived from the systematic risk exposures in the SAA. The SAA serves as a benchmark that specifies the appropriate asset mix based on long-term considerations.
This contrasts sharply with the TAA, which refers to short-term adjustments to asset class weightings based on the expected performance of those asset classes. The TAA establishes active risk and therefore active return. Underweighting or overweighting asset classes relative to their strategic weightings should add value to an investor’s portfolio. This can be considered an overlay strategy, according to William F. Sharpe, Peng Chen, CFA, Jerald E. Pinto, CFA, and Dennis McLeavey, CFA, in “Asset Allocation,” from Managing investment portfolios: a dynamic process.
The TAA is based on the deviation of expectations from the long term, as well as on the perception of imbalances. The SAA is derived from long-term capital market expectations, as described above. The TAA exploits the deviation of asset class values from the expected long-term relationship.
TAA decisions are guided by the position of assets in the economic cycle as well as expected inflation, changes in central bank policy, and changes in the riskiness of assets. Regarding the former, the variation in the economic cycle plays a key role when it comes to the TAA. It matters whether the current stage of the cycle is an expansion or a recession. Once it is determined which asset class is currently in favor, the sub-asset classes can be further analyzed. Valuations, economic data, and technical and sentiment variables are key in this regard.
Tactical overlay strategies particularly offer flexibility as ultra-loose monetary policy in much of the world comes to an end. The era of free money has led to high valuations in equity and bond markets: a common discount rate shock could be what capital markets need to start the normalization process. Therefore, a consistent TAA process can take advantage of deviations from long-term expected returns and perceived imbalances.
As such, tactical asset allocation is a source of risk monitoring, with the ASA serving as a benchmark. Certainly, in “Tracking Error and Tactical Asset Allocation“Manuel Ammann and Heinz Zimmermann show that intra-asset class active management is a greater source of risk to SAA than TAA. Nevertheless, the expected benefits of TAA must also be weighed against the costs of adjustments. tactics.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.