Last Updated on 20 April, 2021 by Samuelsson
Tactical Asset Allocation
The essence of investments is to make as much return as possible while keeping the risk low. So, when building a portfolio, investors try to not only diversify it across several assets but also allocate their capital in a way that minimizes risks and increases potential returns.
But the financial markets are very dynamic, with the conditions changing from time to time, which means that the investor or portfolio manager needs to also keep adjusting the portfolio to take advantage of the new market conditions. This is where tactical asset allocation comes in.
What is Tactical Asset Allocation?
Tactical asset allocation (TAA) is a dynamic investment portfolio management strategy whereby the portfolio’s asset allocation is actively adjusted to take advantage of market pricing anomalies or strong market sectors. In other words, the tactical asset allocation strategy is an active management portfolio strategy in which the portfolio manager shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors.
The essence of a tactical asset allocation strategy is to improve the risk-adjusted returns of passive management investing. Thus, the strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace to either minimize risk or improve returns. It is a moderately active process because the portfolio managers eventually bring the portfolio back to its original asset mix once the desired short-term target is reached.
The TAA strategy is not about stock picking; the focus is on choosing the asset categories (stocks, bonds, commodities, and cash) to invest the capital and how much to allocate to each category. So, tactical asset allocation differs from other investment strategies, such as technical analysis and fundamental analysis, in that it focuses primarily on broad asset allocation and not specific market analysis and timing. But the ultimate goal of the tactical asset allocation strategy is to maximize portfolio returns while keeping market risk to a minimum.
Understanding Tactical Asset Allocation
Now, let’s try to understand how tactical asset allocation works and how to use it in your own investment strategy. As you know, there are different asset classes you can invest in, such as stocks, commodities, and bonds. Of course, the investment capital can also be kept in cash, but while cash protects against market risks, it yields no returns, and inflation can bite it hard.
Basically, the underlying logic behind tactical asset allocation is that portfolio management should primarily focus on asset allocation and secondarily on the selection of the specific securities that make up the portfolio. With the tactical asset allocation strategy, you look at the “bigger picture” because the allocation of assets exerts a greater impact on portfolio returns than the individually selected securities — you keep monitoring the markets and adjusting the portfolio mix as market events unfold.
However, tactical asset allocation differs from strategic asset allocation and rebalancing, and to understand it, you need to understand those two.
How is Tactical Asset Allocation different from Strategic Asset Allocation?
Strategic asset allocation is the percentage of weighting that each asset class has over the long term, which is carefully chosen to enable the portfolio to meet its specific targets. Thus, with strategic asset allocation, a portfolio manager may create an IPS (investor policy statement) to set the strategic mix of assets for inclusion in their portfolio.
To do this, the manager will look at many factors that can affect the performance of the portfolio, such as the acceptable risk levels, expected rate of return, legal and liquidity requirements, taxes, investment duration, and other relevant circumstances in the market. With these considerations, the manager chooses a mix of assets and the weights of each asset class in a way that can help the portfolio meet the required goals. For example, a typical portfolio’s strategic asset allocation may look like this:
- Cash = 10%
- Commodities = 15%
- Bonds = 25%
- Stocks = 50%
Tactical asset allocation, on the other hand, is the process of actively monitoring the markets and adjusting weights of assets in the strategic asset allocation over the short term to take advantage of the prevailing market or economic opportunities. For instance, let’s assume that there will be a significant increase in the demand for commodities over the next year. A prudent portfolio manager may decide to move some of the cash reserves into the commodity category to take advantage of the opportunity — after all, idle cash won’t make any returns. With this move, the portfolio’s strategic allocation will remain the same mixture of four asset categories, but the tactical allocation for that period will become:
- Cash = 5%
- Commodities = 20%
- Bonds = 25%
- Stocks = 50%
It is also possible to do tactical allocation maneuvers within an asset class. For example, let’s say that of the 50% strategic allocation of stocks, 25% are in small-cap stocks while the other 25% are in large-cap stocks. If the prospect of small-cap stocks looks unfavorable, a prudent tactical decision could be to reshuffle the allocation within stocks to maybe 10% small-cap stocks and 40% large-cap stocks over the short term until the market conditions change.
The usual range of tactical maneuvering in a portfolio is 5% to 10%, but it may be lower. Tactically adjusting an asset by more than 10% is rarely seen in practice. When there is a large adjustment during tactical asset allocation, it shows a fundamental problem in the construction of the strategic asset allocation.
How is Tactical Asset Allocation different from Rebalancing?
Tactical asset allocation is different from rebalancing a portfolio because the essence of rebalancing is to bring the portfolio back to the original strategic asset allocation. That is, during rebalancing, trades are made to bring the weights of the various asset groups in the portfolio back to the initial strategic asset allocation.
While tactical asset allocation adjusts the strategic asset allocation in the short term, with the intention of reverting to the strategic allocation once the short-term opportunities have been captured, rebalancing is bringing back the portfolio to its strategic allocation a short-term tactical adjustment or following market conditions that naturally alter the strategic allocation without a prior tactical touch.
How Tactical Asset Allocation actually works
So, how does tactical asset allocation work?
Well, from what we have discussed so far, you will see that an investor or a portfolio manager will normally have a strategic asset allocation model for the long term, employing an appropriate weighting to create a prudent mix of assets suitable for their risk tolerance and investment objectives. For instance, if this investor or portfolio manager chooses a moderate portfolio allocation, it may be targeted at 50% stocks, 30% bonds, 10% commodities, and 10% cash.
Then, as time goes on, this investor monitors the prevailing market and economic conditions and tactically adjusts the asset allocation to take advantage of the condition to either improve returns or reduce risk. Based on those prevailing conditions and the objectives of the investment, the allocation to any particular asset or group of assets can be either neutral-weighted, over-weighted, or under-weighted. A neutral-weighted asset is one that performs on par with the market; overweight assets outperform the market, while underweight assets underperform.
In our example above, the investor’s target allocations were 50% stocks, 30% bonds, 10% commodities, and 10% cash, and they may be said to be “neutral-weighted.” Assuming that market and economic conditions change along the line and stocks become relatively overpriced — a bull market appears to be in the maturity stages — the investor may now believe that a market downturn may be around the corner. As a result, the investor may decide to reduce their risk exposure in stocks and move toward a more conservative asset mix — say 45% stocks, 35% bonds, 10% commodities, and 10% cash.
In this case, the investor has reduced the weight of stocks and increased the weight of bonds. If the anticipated bear market starts appearing, the investor may continue to pull out of the stock market gradually. Eventually, the investor may be completely out of the stock market and stay in bonds, commodities, and cash by the time bear market conditions are evident.
Also, when the bear market is giving way for a new bull market, tactical asset allocation requires that the investor builds the portfolio again and slowly add stocks to the portfolio composition to benefit from the new bull market. It is, however, important to note that tactical asset allocation differs from absolute market timing. Tactical asset allocation is slow, deliberate, and methodical, whereas timing often involves more frequent and speculative trading.
As we stated earlier, tactical asset allocation is an active investing style that incorporates some passive investing and buy-and-hold qualities because the investor is not necessarily abandoning asset types or investments but, rather, changing the weights or percentages. Moreover, TAA is not about picking individual securities in an asset class.
The reasons for Tactical Asset Allocation
As you must have observed from our discussion so far, there are many reasons why investors and fund managers employ the tactical asset allocation strategy in managing their investment portfolio. These are the key ones:
Tactical asset allocation is a flexible and responsive way to adjust your investment portfolio in line with the macroeconomic events of the moment. With the TAA strategy, you won’t be caught unawares; you will be able to actively manage the risk exposure in your portfolio by adjusting the weights of different asset categories in your portfolio.
For example, during the stock market crises in 2000 and 2008, stocks significantly underperformed several other asset classes. With a tactical asset allocation strategy, you could have moved your capital from stocks into other assets, even if it was just keeping them in cash, to protect it during those bear markets. Shifting the asset allocation accordingly to account for macroeconomic conditions is one of the primary reasons for TAA.
Apart from reducing risks, tactical asset allocation (TAA) can be used to improve returns. Using tactical asset allocation to shift asset allocations to stronger performers increases your portfolio return. By doing so, you allow the portfolio to capture the upside in an asset class while moving away from poorly performing asset classes.
Thus, at any point in time, your asset allocations are structured in a way to give you maximal returns without risking too much, which is the main goal in investing. So, when the stock market is doing well, you increase your allocation to stocks and even go as far as increasing your allocation to the market sector that is performing the most. Conversely, when stocks are not performing well, you reduce your allocation in stocks and shift to other assets like bonds, commodities, and even cash.
Allocating your investment capital to different asset categories is called diversification, and it inherently reduces risks, unlike investing solely in one asset class which increases the risk of the portfolio. The TAA strategy is a form of diversification on its own because your capital is allocated to different asset classes and actively adjusted to suit the prevailing market and economic conditions.
Tactical asset allocation helps you to optimize your diversification strategies so that you can potentially realize greater returns with lower risks. In other words, it allows you to take the full benefits of diversification in the very dynamic market environment.
Types of Tactical Asset Allocation
There are different ways to classify the tactical asset allocation strategy, but we will discuss these two:
- Based on how the asset allocation is being implemented
- Based on the asset involved
Based on how the asset allocation is being implemented
When you are considering how the asset allocation is being carried out, there are two ways to implement the TAA strategy:
Discretionary Tactical Asset Allocation
In discretionary tactical asset allocation strategies, you adjust your asset allocation taking into consideration the current valuation of the markets in which they are invested. In this case, you are using your own discretion to know when it is time to alter your asset allocations and by how much to alter them.
For example, if you are invested heavily in stocks, you might want to reduce your stock allocation when you perceive that other securities, such as bonds and commodities, are poised to outperform stocks, or you might want to pull out of stocks if you think that your stock positions expose you to too much risk.
However, TAA is unlike stock picking, where you predict which individual stocks will perform well. In tactical asset allocation, you are judging the future return of complete markets or sectors. You may think of it as a natural supplement to mutual fund investing, including passive management investing.
Systematic Tactical Asset Allocation
Unlike in the discretionary approach where you use your judgment to make tactical asset allocation decisions, in the systematic tactical asset allocation approach, you use a quantitative investment model to systematically exploit inefficiencies or temporary imbalances in equilibrium values among different asset classes. The key factor here is the use of quantitative models to allocate capital across asset classes at the right time and in the right proportions.
The quantitative models are often based on financial market inefficiencies that have occurred in the past and are supported by academic and practitioner research so that you can exploit similar inefficiencies when they occur in the future. Many systematic TAA strategies, for example, try to use quantitative trend-following or relative-strength techniques to capitalize on anomalies in market momentum so as to produce excess returns.
Based on the asset involved
Tactical asset allocation can be carried out in any of these ways:
Putting more capital on a specific sector that is performing well
One way to implement the TAA strategy is to move more cash to an asset class that is performing exceptionally well. To do this, you must have a sizeable portion of your portfolio in cash waiting to be allocated to an exceptionally performing asset class.
For example, let’s assume you have a portfolio that is made up of 50% stocks, 30% bonds, 10% commodities, and 10% cash, and the commodity market just happen to be performing exceptionally well at that moment, while bonds and stocks aren’t doing badly. In this case, you can move about 5% from cash to the commodity section.
Moving from one asset class to another
There can be scenarios where one asset class is not doing really well at the moment. In that case, you may want to limit your risk in that asset class, so you decide to tactically reduce the allocation in that asset class by moving your capital from there to another asset class.
For example, if there is a stock market crisis, you don’t stand a chance of not making money but also run the risk of losing your money. In that case, you may want to move your funds to more secure fixed-income assets, like government bonds. This way, you protect your capital from ruins while also making some returns.
Asset reallocation within a sector
It is also possible to tactically reallocate funds within an asset class if a sector of the asset class is doing better than the others. For example, let’s say that 20% of your stock portfolio is in the tech sector, 30% in the energy sector, and 50% in other sectors, and the tech sector is having a great run. You may choose to reshuffle your stock portfolio and probably increase the weight of tech stocks in your portfolio to 40% or more.
An example of Tactical Asset Allocation in use
To understand how tactical asset allocation is used in real life, let’s take a hypothetical case of a fund manager, Mr. Don, who wants an asset allocation consisting of 60% stocks, 30% bonds, 10% commodities, and 5% cash since stocks have performed extremely well in the past.
After some months, Mr. Don noticed that the yield curve has inverted, which is a strong indication of a potential recession. The fund’s quantitative analysis shows that the best portfolio mix at the moment is 20% stocks, 50% bonds, 20% commodities, and 10% so as to protect the portfolio from the potential poor stock returns. By implementing that, Mr. Don is employing a tactical asset allocation strategy.
Real word statistics
Reports show that about forty-six percent of respondents in a survey of smaller hedge funds, endowments, foundations, and other institutions involved in wealth management were found to use tactical asset allocation techniques to beat the market by riding market trends. By using the TAA strategy, these investors and financial advisors are looking at the big picture and essentially trying to leverage the modern portfolio theory, which states that asset allocation has a greater impact on portfolio returns and market risk than individual investment selection.
Criticisms of Tactical Asset Allocation
While it is generally believed that investors make use of the tactical asset allocation strategy to hedge risk in a volatile market and improve returns, some critics of the strategy, such as Larry Swedroe of CBS MoneyWatch, see it as an attempt to time the market and an excuse for managers to make money from trading fees since the strategy requires frequent buying and selling.
A study conducted by Morningstar, Inc., which examined the “net annualized return, standard deviation, Sharpe ratio, and maximum drawdown from July 31, 2010, to December 31, 2011,” of 163 tactical funds, showed that only a small percentage of firms outperformed the Vanguard Balanced Index.
Tactical Asset Allocation with Index Funds, Sector Funds, and ETFs
Interestingly, index funds and exchange-traded funds (ETFs) are good investment vehicles for the tactical asset allocation strategy since the focus is primarily on asset classes, not the individual securities themselves. For instance, an investor who has low-risk tolerance may simply choose to invest in stock index funds, bond index funds, and money market funds, instead of building a portfolio of individual securities. It is also possible to choose specific fund types and categories of stocks, such as large-cap stock, foreign stock, small-cap stock, or sector funds and ETFs.
Thus, when selecting sectors during tactical asset allocation, an investor may choose sectors he or she believes will perform well in the short term and intermediate-term. If, for example, the investor feels that real estate, health, and utilities may have superior returns compared to other sectors over the coming years, he or she may buy ETFs that represent those sectors.
Another good resource. A Quantitative Approach to Tactical Asset Allocation