At first, tactical asset allocation (TAA) appears to have several meanings, however this is due to various interpretations and recent significant changes in approach. There are two main interpretations.
The first one is the old balanced mandate, where the manager had the opportunity to switch between different predefined asset classes with given allocation ranges. In most cases these asset classes were German (or Europe) equities and German (or European) government bonds. However, in some instances, there was more latitude, such as the possibility of adding corporate bonds or other assets with similar risk characteristics.
The second is the growing focus on risk which has arisen from dramatic changes in the way that pensions funds and pension-related money is invested and monitored in Germany.
A lot of institutional investors are now obliged to monitor their risks far more closely than they used to do some years ago. Long-term investors, with some risk appetite, have in many cases now changed to being a disciplined risk controller that monitors most of the different investment risks over shorter term horizons, generally the next year end.
Therefore, investors are increasingly looking for flexibility to adjust the allocation between different asset classes depending on risk tolerances. Needless to say this trend has been driven by very difficult market conditions of the last few years combined with other pressures such as longevity risk.
As a consequence of these developments many institutional investors are changing the way they look at investment opportunities, moving away from a return-related view to a value at risk perspective. Hence some investors are now not focusing exclusively on relative benchmarked returns from certain asset classes but rather on the space taken up in the risk budget by that asset class, generally on a 12-month horizon.
In our view, it is not a good idea to think of an asset manager as one suitable to monitor an investor’s risk relative to their liabilities.
The differences between the two sides of the balance sheet are far too big to rely on an asset manager’s attempts to try to match their decisions, made on the asset side, with the fast-changing, unpredictable and complex liability side.
We believe that the best solution is to establish a risk framework, using parameters decided by the fund, within which the asset manager can work to meet the investor’s expectations.
These expectations should not only be loose, like ‘match the movement of my liabilities’, but rather strict parameters determined by return expectations
and value at risk figures on a three, six or 12 month basis.
The parameter setting itself should be the outcome of a thorough analysis of the liabilities, taking into account all peculiarities of the institution, including goals, restrictions, risk appetite and their investment beliefs.
We believe the optimal starting point for contracting asset management mandates is a professional asset liability study followed by a precise definition of risk through a risk budgeting exercise. Additionally, risk from other parts of the portfolio should be taken into account to avoid risk correlation.
As is clear there are a lot of differing views on this subject and much debate about TAA products and their position in the German institutional investment world. However, this debate needs to happen if we are going to see clearly through the ‘smoke and mirrors’ which surround the subject.
It is important to note that TAA, when used in traditional balanced mandates, is substantially different when compared to the modern way of implementing TAA. There are four main differences which come to mind:
n The modern versions of TAA use much more well-defined quantitative methods
n In addition, modern approaches use a much broader universe of different asset classes and markets
n The behaviour of most asset classes used as part of TAA are now much more volatile than in past years and most forecasts indicate no sign of decreasing volatility in the near future. This could result in single asset class strategies being more risky, at the same time providing more opportunities for TAA, particularly across different markets
n This is reinforced by the further development of asset markets around the globe, which in turn can produce more sources of alpha.
One important feature of TAA products is the availability in different types of funds for different kinds and sizes of investors. Segregated accounts can make the handling of investments quite difficult.
The trend towards pooled funds in the asset management industry can make life much easier for the investor as it means an end to engagement and a reduction in time spent on administrative issues.
A quite different way of doing TAA is as a total portfolio overlay which is used by some investors in Germany and is called Risk Overlay or Tactical Overlay. Most of the time this serves as a way of controlling value at risk and managing targeted strategic asset allocation and avoids having to ask every single manager to change their allocation. Often derivatives are used for aspect of TAA.
The other way of doing this is often related to Constraint Proportion Protection Insurance (CPPI) approaches where the overall risk monitoring company (often the incumbent consultant or the Master-KAG) has the job of ensuring the minimum return on investment is achieved.
Asset managers in Germany view the TAA segment as one of the fastest growing. In our view this will only hold for that part of TAA which is described as the return-seeking approach to TAA. The other part of TAA, ie allowing asset managers to focus on the overall steering of risk, in our view will stay limited to those pension institutions that, based on a thorough understanding of their own liabilities, are not able to set, monitor and control their own strategic asset allocation themselves and will therefore ask asset managers to do so.
The expectation of producing miracles even in very bad market conditions cannot be fulfilled by TAA products. Instead they should be used for what they are: an asset class with lots of opportunities, the success of which is highly dependent on skill.
One of the main problems of TAA is the relatively small number of managers who offer robust, broad-based global (not just domestic) processes.
Only 14 managers are rated by our manager research team, and we estimate approximately 75 to 80% of assets are concentrated in the hands of the top five. Many managers have claimed to be TAA providers in the past, while not all of them have had the appropriate mix of processes and the ability to cope with complex markets.
Our job as consultants is to select and monitor the most appropriate TAA investment manager that best fits the risk profile and governance capabilities of our client, which can range markedly between small foundations and large insurance company.
Our clients are increasingly looking for ways to implement different investment strategies, including TAA, so for the right managers there are significant opportunities, but for those with an old-fashioned view, business could get very quite.
Torsten Köpke is leader of Watson Wyatt’s investment consulting practice in German