Fixed asset weightings in a portfolio are not optimal when risk premiums and volatility vary over time. This renders tactical asset allocation (TAA) a useful supplement to strategic asset allocation. The institutional investor considering the investment process for TAA should consider the spillover effects to other parts of the investment process, the most efficient way to implement TAA decisions and the degree of outsourcing to external managers.

Why TAA makes sense
Financial wisdom in respect to asset allocation has changed since the 1970s. At this time, CAPM was considered a fairly good description of risk, since returns were believed to be un-predictable and stock market volatility and correlations between assets invariant through time. This implies that an investor who rebalances his portfolio should choose the same asset allocation irrespective of his horizon and the timing of the rebalancing across the business cycle.
Academic research has developed since then. Today, there is a growing body of evidence that returns are predictable due to time-variation in the reward for risk, and research indicates a tendency to mean reversion in equity return. Volatility is also considered to be invariant through time. It is possible to show that stock market volatility is systematically higher in recessions than in expansions since uncertainty and risk aversion is larger during these periods.
In general, there are two ways of exploiting movements in the expected risk and return be-tween assets classes. One possibility could be to rebalance the strategic allocation with a relatively high frequency. For this process, one would need new short run estimates of return, volatility and correlations between asset. The accuracy of these estimates is very limited and even though the method is theoretically attractive the practical implementation seems to limit the usefulness of this method.
Another and more fruitful possibility would be to set up a risk budget and use TAA to exploit the movements in risk premiums between assets. The goal of any TAA strategy must be to improve the overall return per unit of risk. The traditional asset classes include equities versus eg, bonds and high yield, emerging versus developed markets, value versus growth, and small cap versus large cap equities. But a TAA set-up may also include exposures at country and sector level.

Alpha generating process
There is theoretical justification as well as empirical evidence that one may generate excess return by overweighting asset classes with an attractive valuation and exploit the fact that markets overreact to negative information. But timing across the business cycle is also an im-portant part of the process. Higher risk and risk aversion in recessions implies that investors seek protection in secure assets when the economic climate deteriorates and return from these “safe havens” when the economy improves. Generally these movements in risk aversion will indicate that emerging markets outperform the developed markets, that small cap equities outperform large cap, and that high yield and later equities outperform treasuries as the economy moves from recession to expansion.
Developing an alpha-generating model for TAA that exploits the movements in risk premiums, is costly and time consuming. But once developed, the model may add information about ‘flight to quality’, market timing and other trends which may affect the risk premium between asset classes as well within the asset classes. Although investors are able to handle the implementation of TAA-decisions themselves, TAA advisory based on a systematic alpha-generating model/process may by itself add value to the institutional investor.

Implementation of TAA decisions
TAA has attracted attention as a result of the increased specialisation among active managers. A decade ago, balanced mandates were the dominant theme, today institutional investors are increasingly allocating their portfolios into smaller and more specialised segments. This makes market timing more difficult as the overweighting of an asset class could result in allocating money from one manager to another resulting in significant trading costs and a relatively slow implementation of TAA decisions.
Regardless of who is to manage the implementation programme of the process (the institu-tional investor or an external manager), futures and forwards are critical in reducing the transaction costs of rebalancing. Liquid futures exist in all major global markets and asset classes. It is possible to increase exposures in equities by buying (selling) a basket of index futures and selling (buying) a similar basket of interest futures. For example, it is possible to construct a basket of five index futures tracking the MSCI-world with a tracking error below 1%. The cost for trading this basket is approximately 10 % of the costs of buying and selling the underlying assets.
From a cost as well as an operational point of view, futures offer a means of generating index returns that are flexible and efficient.
Bo Sørensen and Keld Holm are with Danske Capital in Copenhagen

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