Each asset allocation strategy has its merits
Achieving the right asset allocation is vital in fulfilling an investor’s financial plans. When establishing asset allocation, professional investment managers tend to adopt one of two investment strategies – strategic or tactical. Each strategy has its merits – and no two investors are the same – so the decision as to which to adopt lies with an individual and a trusted financial advisor.
What is strategic asset allocation?
Strategic asset allocation involves defining portfolio asset allocations from the outset, based on historical performance and volatility data over a representative period. Managers use significant resources to review these data, focusing on the long-term risks and returns within each asset class. When creating the portfolio, managers establish an asset mix based on the expected risk and return dynamics of each asset class.
Managers adopting this strategy do not focus on exploiting short-term valuation opportunities brought on by a change in sentiment toward different asset classes. They analyze the performance of different assets over the long term and build portfolios with a mix of assets that could deliver the best possible outcome for a given risk level. When using this strategy, asset allocations will only be changed where there is a significant shift in the long-term outlook of any particular asset class.
To preserve the portfolio’s risk and return characteristics, asset class mixes are usually rebalanced to the target weights at regular intervals, eg quarterly or semi-annually. The process of rebalancing involves selling those assets that have outperformed and reinvesting the proceeds in assets that have underperformed, which retains the original asset allocation.
What is tactical asset allocation?
Tactical asset allocation, in its simplest form, adopts the long-term asset class weightings of a strategic portfolio. However, it gives investment managers the flexibility to alter those weightings according to market conditions and within a risk-controlled framework.
Managers typically evaluate the relative attractiveness of property and equity markets, bonds and cash through financial valuation, growth and sentiment measures. They often use a systematic process to assess the current attractiveness of those asset classes and alter the weightings accordingly.
Managers seek to create an additional source of return by adjusting the weightings between asset classes. They aim to capitalize on short to medium-term market inefficiencies by managing investors’ exposure to the different asset classes within an appropriate risk framework. The resulting additional trading costs must be recovered in additional gains for the manager to outperform relative to a strategic portfolio.
Tactical asset allocation is usually based on the belief that markets are inefficient. It attempts to capture incorrect asset class valuations to generate a higher risk-adjusted return. Asset allocations are dynamic by nature, so a portfolio’s risk level may change according to the manager’s views.
Which strategy is better?
The answer to this question is hotly debated by the advocates of each strategy, according to Future Start Financial Planning. Both sides agree that the overall strategic asset allocation significantly affects the variability of returns over the long term. However, they have opposing views on how to manage that allocation in the short term.
Advocates of strategic asset allocation argue that, over the long term, the performance and volatility of each asset class will remain relatively constant and adjusting asset weightings in the short to medium term will equally as likely end in failure as in success. Thus, they promote keeping the asset mix in line with the investor’s long-term goals and striving to retain this blend through rebalancing.
The debate centres on the tactical manager’s ability to identify short to medium-term inconsistencies in asset prices and exploit them for the investor’s benefit. It could mean reducing a weighting in an asset class they believe is overvalued and buying into an asset class they think is undervalued or attractively valued. The aim is to yield a risk-adjusted return above that of strategic asset allocation.
Tactical managers strive to identify market inefficiencies and make judgments that provide opportunities to outperform. However, this strategy involves significant ongoing research, trading and other associated costs, which must be recovered through additional portfolio gains before managers can demonstrate outperformance against a strategic portfolio.
This is the bottom line: Managers structure a series of strategic and tactical portfolios to achieve returns for varying risk levels. One style will not necessarily provide a better return or less volatility than the other over the long term. It comes down to what extent you believe markets are efficient and whether it is possible to forecast relative asset class movements over the short to medium term.
Either strategy can be suitable for an investor, depending on personal preferences. Strategic asset allocation may be right for those who want to keep things simple and avoid the additional costs that come with tactical asset allocation. Meanwhile, the latter may appeal to those who prefer to adopt a more active asset allocation in their portfolio.