Tactical asset allocation (TAA) is an investment style wherein the three primary asset classes (stocks, bonds and cash) are actively adjusted and balanced. Tactical investing involves short-term planning and assessments that allow investors to switch a portfolio between asset classes, depending on which possess the most desirable risk and reward characteristics. Its ultimate strategy is to maximize portfolio returns while keeping market risks to a minimum, as compared to a benchmark index.
Why should investors consider using tactical asset allocation?
There are four reasons investors should consider making TAA part of their portfolios:
First, asset classes go through bull and bear markets. A relative strength-driven TAA strategy aims to overweight those asset classes in favour and underweight those that are out of favour.
Second, many investors cannot handle the volatility associated with a buy-and-hold approach of investing in just one or two asset classes. TAA has the potential to provide a portfolio with the diversification it needs.
Third, from a client-management perspective, investors want to see how their portfolio is adapting to the current environment. They want flexibility, and a tactical strategy can provide that as it seeks to respond to market trends objectively.
Finally, markets are increasingly becoming global. An investor’s portfolio should reflect markets’ global nature by having the flexibility to invest in a wide range of asset classes, including domestic and international equities, currencies, commodities, fixed income, and real estate.
In addition, TAA portfolios will have two main advantages when designed properly and executed successfully:
First is risk mitigation during severe bear markets. TAA’s primary investment objective is to mitigate a balanced portfolio’s decline when market prices are severely falling. You can most clearly understand the benefit of such mitigation by reviewing the history of bear markets.
The other advantage is return enhancements when markets are realizing a higher-than-normal level of trading. TAA’s secondary investment objective is to provide outperformance when markets are trading in a level that is higher than what is normally experienced. This phenomenon, which is known as trending, is best described as the market’s propensity to keep doing what it has been doing, eg keep going up.
TAA can be a remarkably attractive investment strategy in times of strongly trending markets, in preparation for a coming severe bear market, and particularly so for investors’ tax-deferred accounts or for taxable accounts of those in low-marginal tax brackets.
What are the types of tactical asset allocation?
TAA can be either discretionary or systematic.
In discretionary TAA, investors adjust asset allocation according to valuations of the markets where their assets are invested. For instance, heavy stock investors may want to reduce their stock holdings if bonds are expected to outperform stocks. But unlike stock picking, TAA involves judgments on entire markets or sectors. For this reason, some investors see it as supplemental to mutual fund investing.
Meanwhile, systematic TAA uses a quantitative investment model to take advantage of inefficiencies or temporary imbalances among different asset classes. These are often based on known financial-market anomalies and backed up by academic and practitioner research.
A single TAA strategy will perform well in most (but not all) environments. To help mitigate the effects of the ebbs and flows of relative performance, investors can use multiple tactical strategies. Each of the strategies can be governed by different sets of rules and asset classes. Those rules and asset classes will, in turn, perform differently in the various stages of a market cycle. When one strategy underperforms, another strategy can outperform.
What should investors consider when choosing a tactical asset allocation portfolio?
Generally speaking, investors should consider three things when constructing a TAA portfolio:
One major consideration is performance. The performance of TAA portfolios varies significantly based on their investment goals. They need to be checked for variance – how closely they represent the performance of major asset classes.
Risk tolerance is another thing to consider. Some investors use TAA strategies as a single-portfolio solution while others use TAA as part of a wider investment strategy.
The third important consideration is investment time horizon. Choosing the right time horizon also matters because TAA portfolios have multiple extremes. At one extreme, TAA allows portfolios to function essentially like day traders. At the other end of the spectrum, TAA sometimes mirrors the business-cycle time horizon, which is much longer than the one day traders are accustomed to.
It is important to note that although tactical asset allocation can be associated with market timing, the former is slower, more deliberate and methodical while the latter often involves more frequent and speculative trading. It also differs from portfolio rebalancing. During rebalancing, trades are made to bring a portfolio back to its desired asset allocation. Tactical asset allocation, however, simply adjusts the allocation for a short time with the intention to revert it once the short-term opportunities disappear.