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