Back in favour
What is global tactical asset allocation (TAA)? TAA is a label given to any type of investment strategy in which the manager seeks to add value through asset allocation and currency management decisions rather than through security selection decisions, on a global basis.
Global TAA managers will typically seek to add value in the following four ways:
q Through country selection within equities;
q Through country selection within bonds;
q Through equity/bond/cash allocation decisions, taken either on a global basis or separately within each country, or both; and
q Through currency management decisions.
Some global TAA strategies may seek to add value in other areas as well, such as active management of allocations to inflation-linked bonds, credit, large cap versus small cap, commodities and real estate. However these other areas normally account for a relatively minor component of the overall investment process.
Investment managers have attempted to add value through managing the asset mix within balanced portfolios ever since investment management began.
Specialist TAA strategies that sought to add value solely through asset allocation first appeared in the US in the early 1970s. They were US domestic TAA strategies that sought to add value through managing the mix between US equities, US bonds and cash only. Growth in their usage was initially quite slow but their popularity picked up after some of the leading TAA were seen to help save their clients from the worst of October 1987 stockmarket crash, only to wane again during the long bull run of the 1990s.
Global TAA strategies started appearing in the early 1990s. They differed from domestic TAA strategies in that they allowed managers to take positions on all major equity, bond and currency markets globally rather than just on domestic equities versus domestic bonds versus cash.
This wider opportunity set gave TAA managers scope to diversify their active bets more broadly, which in turn allowed them to achieve more consistent outperformance. Global TAA mandates were typically implemented as overlays on existing portfolios, with investment guidelines customised to meet the needs and preferences of each individual client.
By the late 1990s several managers had started making their global TAA strategies available in the form of pooled funds. These funds obviated the need for clients to go through the complicated process of negotiating customised investment guidelines for each account, which often ended up hindering rather than helping performance. With pooled global TAA funds, the only decisions clients need to make are how much to allocate, and where to source this allocation from. Most pooled global TAA funds allow some degree of leverage to keep the amount of capital that clients need to allocate to these funds to a minimum.
This evolutionary path led to global TAA funds being virtually indistinguishable from global macro funds, which had developed separately in the hedge fund world. Today global TAA funds are used both by traditional institutional investors who are seeking to implement global TAA mandates and by hedge fund investors who are simply seeking good returns.
So why did TAA get such a bad name in the 1990s? This happened separately in the UK and the US, and for different reasons.
In the UK, poor quality TAA management within many UK balanced funds gave TAA a bad name. Often the TAA decisions for these funds were taken by committees of people who each spent only a tiny proportion of their time on TAA decisions and a much larger proportion doing something else. Perhaps unsurprisingly, the value added through these TAA decisions was patchy at best, although there were some exceptions.
In the US there were two main reasons. First, a number of new products were launched after a number of leading US domestic TAA managers performed very well during the 1987 crash. In some cases the managers concerned had underestimated how difficult it was to add value within the confines of a US domestic TAA mandate and their products failed to live up to expectations.
Second, there was a widespread belief that TAA was a bad thing that should be avoided. This view was reinforced by some studies published in the US which gave the misleading impression that adding value through TAA management was more difficult and risky than it really was.
The results of these studies were typically presented in the form of a table along the following lines:
The ‘out of the market’ figures show what your average returns for the whole 25-year period would have been if you had invested in equities for the entire period apart from a small number of months in which you decided to shift tactically into cash instead, which turned out to be the worst possible months to do this in. Had you done this for just 20 months, and your market timing was as bad as it could possibly be, then your average return for the 25-year period as a whole would have been lower than had you simply invested in cash for the whole 25-year period. This type of analysis has often been cited as proof that TAA does not work.
However these results only showed one side of the story. The other side is what the results would have looked like if your market timing calls were perfectly right rather than perfectly wrong. If they had been perfectly right, the table would have looked as follows:
Clearly the ‘why market timing does not work’ studies were one-sided, just as is the ‘why market timing does work’ study in the opposite direction. All that these studies really tell us is that there is scope to add a lot of value through TAA if you do it extremely well, and to subtract a lot of value if you do it extremely badly. These are things that can be said about any form of active investment management.
But have global TAA managers been adding value? The chart plots the median excess returns for the Mercer Global TAA Universe for the eight-year period ending 31 December 2005. This universe contains 19 track records relating to 16 different managers that offer stand-alone global TAA strategies. Each track record is expressed in the form of excess returns rather than total returns, to enable track records for accounts with different benchmarks to be compared with each other. Most of the track records are in fact asset-weighted composites of the excess returns across all accounts that have ever been managed by the manager concerned.
The vertical columns in the chart show the median excess returns (or value added) on a quarter-by-quarter basis. The solid line shows the rolling one-year excess returns.
The chart shows that the median manager in this universe has added value more often than not in recent years. As always, past performance should never be relied on as a guide to future performance, but if nothing else this chart gives us empirical evidence that this group of global TAA managers has added value more often than not in the past.
What about the future? The key question that needs to be asked is why global TAA managers should have better prospects for outperforming than any other type of active manager going forward. Will the value added keep coming, or will there be some sort of reversion to the mean (or even a reversal) as global TAA becomes more popular?
My view is that there are three sound reasons to expect skilled global TAA managers to continue to perform well on average.
The first is that the vast bulk of pension funds, mutual funds and other large institutional investors tend to stick fairly rigidly to their benchmark asset mixes, and make little or no attempt to seek to add value by actively managing their asset mixes. Widespread adoption of this type of approach to managing money gives rise to anomalies and inefficiencies between markets that active global TAA managers can seek to exploit.
The second reason is that, among the smallish minority of investors that do make some attempt to add value through actively managing their asset mixes, most do not do this very well. At the institutional level, the committee approach mentioned above in relation to UK balanced funds is still used in many cases, and not just in the UK. At the individual retail investor level, the ‘rear view mirror’ approach of overweighting whatever performed well last year is commonplace. Hence there are plenty of ‘systematic losers’ around that skilled global TAA managers can take advantage of.
Third, the transaction costs faced by global TAA managers in mainstream equity, bond and currency markets are much lower than those faced by active managers seeking to add value in other areas such as active equity or bond management. This makes it easier for global TAA managers to convert any inefficiencies or anomalies that they identify into value added.
Bill Muysken is global head of research at Mercer Investment Consulting, based in London