New Age for Tactical Asset Allocation
There have been many changes across the institutional investment landscape post-financial crisis, with one of the more intriguing being the willingness of institutional investors to consider and implement tactical asset allocation strategies.
Since the development of current institutional investment governance practices, which started evolving in the mid-1970s, allocating assets tactically has been anathema to investors. However, since 2008 we have seen a subtle, but noticeable, shift in the attitudes of investors towards tactical approaches.
This article will (1) define tactical asset allocation strategies, (2) examine asset allocation practices pre-2008, (3) discuss the factors that are leading investors to consider a change and (4) show how to implement tactical strategies.
What is tactical asset allocation?
No one investor has the same definition of tactical asset allocation. In order to provide clarity, perhaps we can juxtapose tactical asset allocation against what it is not, a method called strategic asset allocation. Strategic asset allocation develops a long-term asset allocation target (how these targets are developed is beyond the scope of this paper) and assets are rebalanced systematically
to the target over time.
Two words in that definition are critical and differentiate strategic from tactical asset allocation: long-term and systematically. By long-term we mean that the targets are intended to be effective for at least three- to five years. By systematic, we mean a rebalancing technique that is rules-based and implemented consistently regardless of market conditions. There are many gradations of tactical asset allocation, starting with an approach that is only slightly different from strategic asset allocation and moving along a continuum that ends with an approach most investors would associate with market timing.
With Level 1 tactical asset allocation, the investor develops a long-term asset allocation target, similar to strategic asset allocation. The differentiation between Level 1 and strategic asset allocation is that there is no systematic rebalancing. In most cases, each asset class within the portfolio has an asset allocation range with an associated target. These ranges may be narrow, for example plus or minus five percentage points from the target. The investor usually develops an opinion about which asset classes are over or undervalued.
Asset class over or underweights, however, mainly occur as a result of asset appreciation or depreciation relative to other asset classes. These asset class over or underweights may be enhanced as a result of cash flow decisions on the part of the investor. For example, if the investor believes that large-cap equities are undervalued, contributions to the portfolio may to directed to large cap equities. A distinguishing characteristic of Level 1 is that the tactical bets are implemented more passively than Levels 2 and 3.
Asset Allocation: Strategic or tactical?