White Papers
Guest Commentary: Tactical Asset Allocation Can Reap Rewards When You Do It Right

Editor’s
note: The role of tactical asset allocation in managing
portfolios can be a
complex business. Here, Alexander Melnikov, director of research
at Performance
Analytics, based in Boston,
MA, runs through the issues that
wealth managers should be aware of.
Portfolio returns in excess
of an index can be achieved through active investment management
in two ways:
security selection, and active (or tactical) asset allocation.
Research shows
that about 90 per cent of risk and return for a typical balanced
portfolio (60
per cent stocks, 40 per cent bonds) comes from policy asset
allocation (source:
Brinson et.al. [1986, 1991]). Clearly, potential for adding value
through
actively managing asset allocation is at least as great as from
active security
selection. However, while active security selection is widely
practiced,
tactical asset allocation has been largely overlooked or out of
favor. Here, we
discuss some of the reasons for this, and describe the process
that should be
followed in order to successfully perform TAA.
TAA is an investment strategy
that centers on altering investment proportions to take advantage
of
differences in expected performance and risks of broad asset
classes (such as
stocks and bonds) or sub-classes (such as US and global
equities). Several
requirements to the investment process stem from this definition.
First, the
responsibility for TAA must be placed with the person (or group)
who’s
responsibilities span across asset classes, and who is authorized
to change the
asset mix. Second, it has to be based on accurate, timely asset
mix information
(actual and benchmark). Thirdly, the effect of these investment
decisions has
to be measured as part of performance evaluation. Lastly, TAA
decisions have to
be largely based on systematic quantitative results rather than
on judgment.
Because the implications to
performance are so large, many family offices already attempt
actively managing
their asset allocation, even if implicitly. If you are a family
office or HNW
manager, you may hear this in your investment strategy
discussions: “We want to
be positioned defensively due to anemic economic recovery in the
US” (or due to “debt crisis in Europe”
or whatever the current concern may be), or “We would like to
take advantage of
the rally in equities.” However, doing this implicitly, without
the proper
process and structure, is dangerously likely to result in
underperformance.
Clearly, successful TAA
requires timely, accurate calls on expected asset class
performance. “Active management
is forecasting,” say Richard Grinold and Ronald Kahn in their
well-known
book Active Portfolio Management. The authors establish
the following
relationship between active return (alpha) and forecasting skill,
or
information coefficient (IC): α = σ × IC × Score