Last Updated on 19 September, 2022 by Samuelsson
While some passive investors are comfortable with a simple buy-and-hold approach, some investors and traders like to actively manage their portfolios based on the prevailing market conditions. One way to invest actively is through tactical trading. And you may be wondering what that is
Also known as tactical asset allocation, tactical trading is an active investing style that alters the allocation of funds to various assets over the short term based on anticipated market trends. The aim is to take advantage of the changes in the market conditions to improve the portfolio’s returns.
We will discuss this topic under the following headings:
- What is tactical trading?
- Understanding how tactical trading works
- Types of tactical trading
- How to implement a tactical trading approach
- Tactical trading vs. strategic trading
What is tactical trading?
Tactical trading is an active portfolio management strategy that alters the allocation of funds to various assets over the short term based on anticipated market trends. It is also known as tactical asset allocation and aims to take advantage of the changes in the market conditions to improve the portfolio’s returns. The strategy focuses on relatively short-lived changes in market outlook based on fundamental or technical analysis.
Most times, tactical trading is combined with a broader strategic asset allocation, which focuses on long-term asset allocation based on fundamental analysis and risk appetite. Tactical trading, in this case, becomes a way to take advantage of short-term changes in the markets by allocating more funds to those markets that are currently performing well. Thus, while the portfolio remains diversified with the long-term strategic allocations, it is tactically reshuffled from time to time to profit from short-term and medium-term trading opportunities to boost overall portfolio returns.
Although tactical asset allocation can be contrasted with longer-term strategic asset allocation, tactical trading is generally more complex and may involve higher risks than the standard strategic trading approach, which is often passive in nature. Tactical trading involves active management, so it often requires far more attention and analysis.
Understanding how tactical trading works
To understand tactical trading, you need to first understand strategic asset allocation. We will get to compare the two approaches later, but for now, let’s explain strategic allocation and use it to explain the tactical approach.
Let’s assume that a portfolio manager has created a strategic allocation plan for a diversified investment portfolio after considering certain factors, such as the required rate of return, acceptable risk levels, legal and liquidity requirements, taxes, time horizon, and other circumstances. Based on these factors, the manager crafted a strategic plan for allocating funds into four asset classes, as follows:
- Stocks = 50%
- Bonds = 30%
- Commodities = 10%
- Cash = 10%
This is the long-term strategic allocation for the portfolio. However, if this asset manager believes from his short-term and medium-term analysis that the commodity market would perform well in the next 2 years, he may want to move more money into the commodity market to take advantage of that opportunity over that period without jeopardizing the long-term strategic plan for the portfolio. The portfolio asset weighting over that period now appears like this:
- Stocks = 50%
- Bonds = 30%
- Commodities = 15%
- Cash = 5%
You can now see that tactical asset allocation, or tactical trading, is the process of making active changes on the strategic asset allocation by adjusting asset weights for a short period to capitalize on the market or economic opportunities. Most times, tactical alterations range from 5% to 10%, but they may be lower. It is unusual, in practice, to tactically adjust any asset class by more than 10%. Such a large adjustment would lead to a fundamental problem with the construction of the strategic asset allocation.
While tactical alterations are made across asset classes, they can also be done within an asset class. For example, the 50% allocated to the equity market could be 25% large-cap stocks and 25% small-cap stocks, but when the outlook for large-cap stocks looks more favorable, the manager can tweak stock allocation to say 37.5% large-cap stocks and 12.5% small-cap stocks for a short time until conditions change.
It’s important to note that tactical asset allocation is different from rebalancing a portfolio. Portfolio rebalancing is a part of the strategic allocation strategy; it is done to bring the portfolio back to its initial asset weightings after one or more assets have significantly outperformed others and altered the asset weightings. Thus, in rebalancing, trades are made to bring the portfolio back to its desired strategic asset allocation, while tactical asset allocation is adjusting the strategic asset allocation for a short time to take advantage of an opportunity in the market, with the intention of reverting to the strategic allocation once the short-term opportunity disappears.
Essential factors in tactical trading
As we stated earlier, tactical trading is an active management style, so the focus is generally on trends or technical indicators rather than long-term fundamental analysis. In other words, technical analysis is the more important consideration in tactical trading strategies since it shows short-term trading opportunities from changes in price trends and often indicates optimal entry and exit points.
However, tactical investors may also follow developments in a market sector, such as new technologies, or even company reports that influence its immediate bottom lines, such as sales, revenue, and earnings.
Thus, while these investors may also use the technical charts and a variety of patterns, channels, trends, and price ranges to identify profitable entry and exit points, they also consider news events that can affect the asset performance over the short term so as to better time their trades and reduce risks. Expectedly, tactical trading is generally more complex and may involve higher risks than standard long-term trading strategies.
By and large, tactical investors seek to exploit short-lived market anomalies and manage their investments in an active manner, taking into consideration significant changes in the investing environment. As a result of the more short-term nature of tactical trading, these types of investors will typically choose to use both technical and fundamental analysis in their investing decisions.
One more thing to note, tactical trading can have tax implications, so the investor may have to check with their accountants and financial advisers to know how to integrate capital gains taxes.
Types of tactical trading
Tactical investors may either use a discretionary tactical trading approach or a systematic tactical method.
In discretionary tactical trading, the investor manually adjusts asset allocation based on market valuations of the changes in the same market as the investment. For example, an investor with substantial stock holdings may want to reduce these holdings if stocks are expected to underperform bonds for a period. In this case, the investor makes a personal judgment on entire markets or sectors using his preferred method of analyzing the markets and then sells the assets to be sold to buy the ones he needs to buy. This is more like asset or sector rotation.
The systematic tactical trading method, on the other hand, uses a quantitative investment model to identify and take advantage of inefficiencies or temporary imbalances among different asset classes. It is often automated and uses a basis of known financial market anomalies, or inefficiencies, backed by academic and personal research.
Implementing a tactical trading strategy: the smart beta example
There are many ways to implement the tactical trading approach in your portfolio construction and management. The most important thing is knowing your long-term investment goal and what you want to achieve in the short term with the tactical approach.
One common tactical trading strategy used within the long-term strategic portfolio construction is smart beta investing, which is a tactical trading strategy that combines the benefits of passive investing and the advantages of active investing strategies. With smart beta, the investor uses alternative index construction rules to traditional market capitalization-based indices; they tend to tilt toward specific industry sectors, or value vs. growth (or vice-versa), or specific market capitalizations.
While there is no single approach to developing a smart beta investment strategy since the goals for investors can be different based on their needs, some managers are inclined to identify and use smart beta ideas that are value-creating and economically intuitive. Generally, equity smart beta seeks to address inefficiencies created by market-capitalization-weighted benchmarks, but funds may take a thematic approach to manage this risk by focusing on mispricing created by investors seeking short-term gains.
Whichever the case, an investor seeking to implement some tactical tweaking to his portfolio from time to time, based on opportunities arising in the markets should already have a strategy for identifying those opportunities and a weighting formula to determine the extent he can alter his strategic allocation plans for that short period.
Tactical trading vs. strategic trading
So far, we have established that “strategic investing” and “tactical investing”, though each involves the periodic adjustment of a portfolio and holding portfolio assets in varied investment classes, describe different approaches to investing. But what are those differences? Well, these are some of them:
- Active or passive: Strategic investing is fundamentally passive because it is all about allocating funds to different assets and holding them for a long time. On the other hand, tactical investing is fundamentally active, as it takes advantage of short-term opportunities.
- Time concept: Strategic investing is about time in the market (staying in the market long enough to benefit from the long-term market growth), while tactical investing is about timing the market.
- The aim: The overall aim of strategic asset allocation is to help manage investment risk while getting some reasonable returns. While it does not totally eliminate the risk, by diversifying across different asset classes, strategic allocation helps to minimize risks. Tactical trading, on the other hand, aims to maximize returns by concentrating funds on the asset with the best opportunity to make money.
- The approach: Strategic investing focuses on an investor’s long-range goals, and it’s often perceived as a “set it and forget it” approach. However, you don’t necessarily set it and forget it forever because there would be a time to rebalance the weightings of the allocations to restore them to the initial plan. That is, the idea is to maintain the way the invested assets are held over time so that through the years, they are assigned to investment classes in approximately the percentages established when the portfolio is created. For instance, let’s say an investor’s strategic allocation plan is to have 60% of his funds in equities and 40% in bonds. However, soon after investing, there’s a long bullish run in the equity market, and the value of the equity investments grew significantly such that equities now constitute over 75% of the total worth of the portfolio. The strategic investing approach requires this investor to rebalance the portfolio to bring it to the planned 60/40 mix by selling some equities and investing in bonds. The tactical investing approach, on the other hand, responds to market conditions by trying to take advantage of current opportunities in the market; it focuses on the present and the near future. A tactical investor attempts to shift the composition of a portfolio to take advantage of new opportunities, which requires making an educated forecast – about when to adjust the portfolio in light of the new opportunities and when to readjust it back to the target investment mix.
- Risks: Strategic investing approach may imply to “buy and hold” and ride out episodes of short-term market fluctuations. On the other hand, the tactical investing approach faces the risk of buying high and selling low.
So, which approach is better? Is it better to buy and hold, or simply, to respond to market changes? Investors have debated this for a long time. While one approach may be better suited than another at a particular point in time, it may be better to employ both approaches.
Tactical trading is an active portfolio management strategy that alters the allocation of funds to various assets over the short term to take advantage of the anticipated changes in market trends. It focuses on relatively short-lived changes in market outlook based on fundamental or technical analysis and aims to improve the portfolio’s returns.