Strategic asset allocation (SAA) determines long-term exposure to systematic risk factors. That said, 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 determines the expected risk and return as well as the cash flow pattern of the portfolio. Empirical analysis shows that asset allocation is the key driver of the 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 that the moment and the security selection account for the rest. In another study, “Does asset allocation policy explain 40, 90, or 100 percent of performance?” Roger G. Ibbotson and Paul D. Kaplan, CFA, focus on 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 is important.
But when it comes to the asset allocation process, we need to distinguish SAA from tactical asset allocation (TAA). At SAA, the long-term capital expectations of different asset classes are combined with an investor’s return goals, risk tolerance and constraints. Based on this, the exposures to the permitted asset classes are determined. The result is a set of portfolio weights for the asset classes. This is called strategic asset allocation or policy portfolio.
SAA should represent the reward for taking systematic risk, or risk that cannot be diversified away. In other words, the returns are derived from the systematic risk exposure in the SAA. The SAA serves as a benchmark that specifies the appropriate asset mix taking into account long-term considerations.
This is in sharp contrast to TAA, which is about short-term adjustments to asset class weights based on the expected performance of those asset classes. TAA establishes active risk and therefore active return. Underweighting or overweighting asset classes relative to their strategic weights should add value to an investor’s portfolio. This can be thought of as an overlay strategy, according to William F. Sharpe, Peng Chen, CFA, Jerald E. Pinto, CFA, and Dennis McLeavey, CFA, in “Asset Allocation,” by Investment portfolio management: a dynamic process.
TAA is based on the deviation of long-term expectations as well as the perception of imbalances. The SAA is derived from long-term capital market expectations as described above. TAA takes advantage of the deviation of asset class values from the expected long-term relationship.
TAA decisions are guided by where the assets are in the economic cycle, as well as expected inflation, changes in central bank policy and the variation in asset risk. Regarding the former, the variation in the business cycle plays a key role when it comes to TAA. It matters whether the current stage of the cycle is a boom phase or a recession. Once it has been determined which asset class is currently in favor, sub-asset classes can be analyzed in more detail. Valuation, economic data and technical and sentiment variables are critical in this regard.
Tactical overlay strategies, above all, offer flexibility as ultra-loose monetary policy in much of the world comes to an end. The era of loose money led to high valuations in equity and bond markets: a common discount rate shock may be just 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 SAA serving as a benchmark. Of course, in “Tracking Error and Tactical Asset Allocation”, Manuel Ammann and Heinz Zimmermann show that active management within the asset class is a greater source of risk relative to SAA than TAA. However, the expected benefits of TAA must also be weighed against the costs of tactical adjustments.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Sebastian Petric, CFA
