The development, added value and management of tactical asset allocation (TAA) is an ongoing topic in the investment field. TAA in its broadest sense can be considered to address three issues:
q Management and control of the strategic benchmark;
q Return enhancement (active TAA);
q Control or reduction of the absolute risk of the portfolio.
This article intends to cover the first two points. Broadly there are two questions we tend to answer: to what should an investor pay attention when using TAA in an investment process, and second, what should an investor consider in deciding whether or not to use TAA? In other words, what is the added value of TAA compared to other return enhancement strategies?
The first point, controlling a strategic benchmark, in fact is not active TAA, but could be considered as the first step of TAA. Clearly investment markets do not move exactly in step over time, and hence a fund’s actual asset allocation will tend to move away from its chosen benchmark, even if the underlying managers have not taken any active TAA positions. There is potential, therefore, for the long-term asset allocation benchmark to be compromised by market movements in just the same way as it can be by active TAA decisions moving the allocation away from the benchmark. One solution is to rebalance the asset allocation back to the benchmark according to some pre-defined mechanistic rules.
While rebalancing as a discipline can be, and normally is, viewed as being distinct from active TAA, it can also be viewed as being a disciplined and impartial first step in TAA. It is also important when analysing performance that returns which result from the drift of a benchmark are separated from those from active TAA to avoid managers being credited or penalised unduly. As we see it, in the Netherlands still a lot of work has to be done regarding this subject.
The more common way to regard TAA is the active TAA process, as noted by the second point. This brings us to the first question we raised: what should an investor pay attention to when using TAA in an investment process? With the desire to take active TAA decisions to enhance the strategic benchmark in the short-term, an investor should develop a means of controlling the risk of incorrect decisions harming performance. Assuming that the benchmark represents a zero or minimum risk position, there are two basic approaches to controlling risk relative to a specific benchmark:
q Limiting tracking error;
q Establishing explicit TAA ranges within which the portfolio must operate.
These two approaches are not mutually exclusive, and some combination might be considered appropriate. We expect that allocating ex ante tracking errors among the various investment decisions will become of more importance. But regarding the question of how an investor can control the TAA process, the second approach is very important. The width of the TAA ranges should be wide enough to enable the investor to successfully exploit the tactical opportunities, but small enough not to compromise the chosen benchmark. An investigation by Watson Wyatt (Ellen Clark and Andrew Hunt) shows that a 5% change in allocation between equities and bonds can change the overall risk profile by 8% (see table).
Most Dutch pension funds choose a fixed percentage of the benchmark weight as their TAA range. Another possibility is to choose ranges that are volatility dependent. We think that ideally, the range is based on the sensitivity of the ALM results for the chosen SAA. If the ALM results show a substantial change of risk by changing the asset mix, the range should be smaller than by less sensitivity.
The table shows the impact of deviations from the benchmark on risk, and hence brings us to the second question: what should an investor consider in deciding whether or not to use TAA? What is the added value of TAA compared to other return enhancement strategies? This boils down to a risk return analysis issue.
The amount of additional return depends on the level of risk taken, but also largely on the skills of the TAA manager. Even if a manager has the skills to add value in the long term, there is clearly a risk that individual decisions will be wrong in the short term. More specifically, the level of out or underperformance depends on:
q The number of different investments available;
q The spread of returns available;
q The size of positions taken;
q The success rate of the managers decisions.
Statistically, the more decisions made, the less the risk overall. With fewer decisions made, the spread of the returns must be higher to attain the same level of outperformance and the size of the position must be larger.
In deciding whether or not to use TAA, we would suggest that an investor compares the risk return of TAA with other forms of active management, like stock selection. The above factors influencing the outperformance of investment decisions all seem to be in favour of stock selection. Namely, stock selection involves many more decisions than TAA. To add the same level of return as a stock selection manager, therefore, a TAA manager will have to take, on average, larger positions, and this results in a substantially higher level of risk. Besides that there is a trigger for a TAA manager to overweight equities as a standard policy because in the long run this seems to be the most profitable strategy; this increases the risk of the portfolio. The risk return trade-off therefore seems to favour investment management processes that make a large number of decisions in a given period (such as stock selection) compared to ones which make a small number (such as asset allocation).
We would suggest that an investor, having decided to use TAA, should limit the risk of other parts of his investment process to keep the overall risk of the portfolio within acceptable levels. In using TAA, we would emphasise the importance of the width of the TAA ranges and the capability of the manager.
Karin Merkus is an investment consultant with Watson Wyatt Brans & Co in the Netherlands