The world has changed. Equity markets have generally disappointed over the past five years and interest rates are at a 50-year low. Institutional investors are being forced to consider fresh approaches to investing in order to boost the low nominal investment returns offered by the market. The search for new sources of ‘alpha’ - the excess return relative to the market or benchmark - has become the key challenge. Tactical asset allocation (TAA) offers a solution.
Every equity investment return can be decomposed into a market return related component, the return generated through exposure to the overall equity market, and a residual amount which is the return generated in excess of the market return. The market component is measured by beta, while the residual is alpha.
In the 1990s, investors did not have to work hard to capture the high-octane returns available in global markets. Strong stock market returns gave little incentive to stray very far from the index. Simply by tapping into the return generated by the broader market - the beta return - investors could capture the double-digit returns they desired.
But the investment environment has changed. Investors can no longer take for granted the attractive returns once available through exposure to the general market. Historically low inflation and interest rates combined with global overcapacity imply that single digit returns are more likely to be the norm in the case of developed equity markets.
Therefore, if investors still crave the higher beta returns they have become accustomed to in the 1990s, they will have to look elsewhere. In short, they will have to travel further along the risk reward curve towards less efficient markets such as emerging markets. An easy switch to make, but one that carries additional risk.
But investors do have another choice. Remember, investment returns can be decomposed into beta – the return captured from exposure to the market as a whole – and alpha, the excess return over and above the benchmark earned by ‘outsmarting’ the market. So how do investors tap into the alpha component of the total return equation? Enter tactical asset allocation (TAA).
TAA is no new concept. But over the last 20 years it has evolved into a refined strategy that has become invaluable in capturing alpha. The theory behind TAA is that equities and bonds, and their sub-sectors, occasionally offer top-down switching opportunities – occasionally since in the long term, such opportunities are arbitraged away and the market reverts to its long-term trend. By successfully identifying these short-term deviations from the long-term pattern, and by acting upon them, an investor can ‘outsmart’ the market for a limited period of time, thereby generating alpha returns.
In the early 1980s, TAA decisions were based upon whether it was ‘smart’ to be overweight or underweight equities versus bonds, and which regional equity and bond market offered the greatest potential to outperform. The asset allocation process used to identify potential alpha opportunities at this time was initially purely qualitative – that is a top-down view would be taken on the comparative attractiveness of one region over another, given economic, political and socio-economic factors.
Over time, the asset allocation process evolved and valuation models became the chosen tool used to identify asset allocation opportunities. But even with these advancements, TAA still only generated a very low information ratio – the statistic used to measure the success of generating alpha compared to the additional risk taken to achieve this additional return.
In the late 1990s, the effectiveness of TAA, based on the valuation model, began to break down. This was because a valuation model could not cope with the prevailing market environment where valuations had become illogical due to the bubble era of the late 1990s. Furthermore, the change in the correlation between bonds and equities meant that taking traditional equity versus bonds bets had become more hazardous.
But there is a new era in TAA that makes the TAA proposition much more attractive. Greater depth in the market has helped to broaden the opportunity set – that is the range of asset allocation decisions that can be made. The old narrow world of possible asset allocation decisions, previously limited to regional and asset class bets, has extended to encompass new opportunity sets.
Decisions can now be made at the ‘cap’ level – small versus large for example. There are also opportunities to make directional decisions or bets at the sector level, and then there is the choice between growth and value. Within the bond market, more refined choices can also be made within emerging market debt and high yield.
Greater liquidity in the index future market and the development of the exchange traded funds market has meant that these alpha opportunities can be more easily transported to a portfolio. These instruments can be used to apply underweight or overweight asset allocation decisions to a portfolio in a faster, more cost effective way.
So there is greater choice in the asset allocation decisions that can be made. But the range in the choice of these decisions also offers a diversification opportunity. If asset allocation decisions can be found to have a low correlation with one another, then the combined information ratios of each individual decision should deliver a higher information ratio overall – even if the information ratio of each decision is low. Why? Because the information sources used to drive individual asset allocation decisions is derived from different parts of the market – just like different slices of a pie. Therefore together the sum of these ratios - the whole pie - boosts the overall information ratio of the portfolio and the overall tracking error of the portfolio can be reduced.
Furthermore, there are additional diversification benefits within each decision itself since each decision is made using a multi-factor model. As such, a variety of information sources, such as valuation and liquidity, are considered and therefore the decision is ‘tested’ in a number of ways. If the signal resulting from the multi-factor model is strong, then the manager would be more ‘convinced’ that the decision to overweight or underweight an opportunity set is more likely to
generate alpha, and therefore the size of the ‘bet’ would be large.
A final note on diversification. The top-down decisions that drive TAA differ from the bottom-up micro investment processes used in stock selection or fixed income selection. As such, the alpha generated through TAA should have a low correlation to the alpha resulting from such bottom-up decisions. Therefore, overall portfolio returns can be enhanced while minimising the additional risk taken to achieve this additional return.
Another important development that makes TAA a more attractive proposition today is the greater level of sophistication in risk management. TAA decisions are based on quantitative models, so it is important to be able to measure the likely accuracy of these models. If the likely accuracy of this information is high, then there should be a strong conviction that asset allocation decisions based on these models will reap the desired results. A comparatively large bet can therefore be taken on this asset allocation decision compared to one where the conviction is low, helping to maximise the overall information ratio. Other advancements in risk measurement also mean that risk can actively be managed throughout the whole investment process.
So, given the opportunity that this new era of TAA offers, what is the best approach to capturing alpha potential from tactical asset allocation decisions? Since factors other than valuation, such as liquidity and technical factors can influence relative returns between and within asset classes, a multi-factor approach should be the most appropriate. It is important to remember that a multi-factor approach is designed to only consider short- to medium-term opportunities, since over the longer term asset allocation opportunities will be arbitraged away.
But analysis should not stop at the purely quantitative stage - qualitative judgements are also important to capture developments that cannot be modeled by a quantitative approach - factors in 2003 included the impact of SARs, the Iraqi war and investors’ behaviour. It is important to emphasise, however, that the most successful TAA model is likely to be quantitative driven, and as such, these qualitative judgements should only form a maximum contribution of say 25% to the investment process, and should in no way override the decisions reached in the quantitative stage.
The changing investment environment presents fresh challenges for investors to capture attractive investment returns. Tactical asset allocation offers a solution. Through searching for, capturing and transporting uncorrelated asset allocation strategies, TAA can help to generate attractive alpha returns.
Peter Schwicht is head of continental European institutional business, JP Morgan Fleming Asset Management, based in Frankfurt