In an environment where cross-asset class volatility is high, there’s a broadly held view among industry practitioners and academics that there are opportunities to improve portfolio outcomes through active asset allocation strategies.
One such strategy is tactical asset allocation (TAA), which is the process of moving portfolios away from a set of targeted exposures (also known as strategic asset allocation (SAA)), because markets have strayed from long-term fair value due to cyclical forces.
Whilst TAA as an investment concept isn’t new, there are varying levels of understanding in terms of its application, targeted outcomes and the preconditions of success. To help demystify the art and science of TAA, we sat down with our Head of Multi Asset and Australian Fixed Income, Andrew Yap, to discuss the benefits, challenges and opportunities presented by TAA, and how it can drive value for portfolios when employed by experienced managers.
What's the attraction of TAA?
Advocates of TAA believe that it can be used to improve portfolio efficiency - enhancing returns and reducing overall portfolio volatility.
For those looking to enhance returns, investors implement TAA for the purpose of supplementing (as opposed to underwriting) total portfolio performance, though the targeted contribution from TAA is likely to be small (circa 0.30% to 0.50% p.a.). TAA can also reduce portfolio volatility through its focus on capital preservation and minimising drawdowns in risk-off environments.
To achieve these objectives, investors target mispriced asset classes, allocating capital away from those deemed to be expensive or at risk of underperforming, in favour of those considered to be undervalued and positioned to outperform.
How do managers work to identify TAA opportunities?
Overall, TAA positioning is driven by custom models and the associated signals produced by the models. While most managers employing TAA look at factors such as investor sentiment, market trends, economic data and whether the source of volatility is expected to be short lived or more persistent, there’s a lot of debate about the relative importance of each.
For those managers placing a greater weighting on macro factors, TAA trades are fewer and less frequent. That said, the level of active risk applied to these trades tends to be larger and directional in nature.
In contrast, focusing on faster moving variables such as investor sentiment and market trends leads to a smaller yet potentially more frequent set of trades. In this scenario, greater emphasis is placed on the implementation of relative-value trade ideas.
What are the preconditions for successful TAA?
To be successful in implementing TAA, managers must demonstrate the ability to identify mispriced asset classes and proficiency in timing market inflection points.
In our view, successful TAA requires the use of a mix of qualitative and quantitative techniques. Qualitative inputs commonly include the consideration of ‘on the ground’ insights and the most contemporary views of asset class specialists. In terms of quantitative inputs, greater focus is placed on the outputs of proprietary models that take into consideration factors such as market momentum and behavioural biases.
Is TAA suited to a particular investment horizon?
Currently there’s no universally accepted view on the investment horizon over which TAA is best suited. We’ve observed a wide divergence of views expressed by multi-asset managers on our Approved Product List (APL). There’s a broadly even split between those managers that suggest TAA is a tool best suited to expressing shorter-term views (i.e. less than one year), and others that believe TAA can have more enduring benefits (i.e. one to three years), reflecting the fact that markets can take time before they return to usual patterns of behaviour.
In our opinion, TAA should be considered a shorter-term portfolio management tool, consistent with the notion that it aims to supplement portfolio returns. In addition, we believe that if TAA positions persist for extended periods, these may be better expressed through strategy selection or refinements to a fund’s SAA.
How does TAA compare to other forms of active asset allocation (AAA)?
There are several alternative active asset allocation strategies implemented by fund managers which have a similar desired outcome to TAA. This includes dynamic asset allocation (DAA), strategic tilting and overlays.
While the common thread across each technique is the goal of delivering investment outcomes that exceed a fund’s SAA, there are also differences. These include the stated investment horizon (i.e. the expression of ultra short-dated or medium-term trade ideas) and targeted portfolio benefits (i.e. basis point trades versus larger directional trades that have the potential to meaningfully enhance portfolio outcomes).
Is there a difference between TAA and rebalancing?
Yes there is - rebalancing is the process of returning a portfolio back to its SAA, where asset class exposures deviate from their neutral setting by a predetermined amount (i.e. +/- 1-2%). Rebalancing occurs irrespective of whether an investment manager has a view on the directionality of markets. It’s a mandated provision focusing on ensuring portfolio performance closely matches that of a fund’s SAA, rather than being inadvertently impacted by portfolio drift.
In contrast, TAA is an active decision, one in which portfolio managers allocate capital away from a fund’s SAA to improve portfolio outcomes.
Is TAA suited to a particular investment approach?
Conceptually, TAA is relevant to portfolio managers implementing either a single or multi-manager approach to portfolio construction, although TAA tends to be more of a 'tool of choice' among those who adopt a single manager approach.
A ‘single-manager’ is one that gains asset-class exposure through investment capabilities offered across internal distribution channels. While a key benefit of this approach is cost-efficiency, a drawback is that investment choice is often limited which can in turn lead to less efficient portfolio outcomes. This is particularly relevant for those that have a relatively narrow suite of sector-specific strategies from which to select and structure asset class exposures.
To help mitigate this perceived shortcoming, many single managers have dedicated considerable resources to building a TAA platform, a trend that has not been as evident across the ‘multi-manager’ cohort of multi-asset strategies. Multi-managers have instead tended to focus their efforts on identifying ‘best in class’ offerings and blending complementary strategies to achieve more tailored sector exposures.
Does TAA really drive value for investors?
While TAA as an investment approach has considerable merit, there are challenges in attributing performance. This reflects limitations of many systems which are unable to isolate the impact of TAA from portfolio drift, manager selection and strategy selection.
TAA is not a panacea, and managers implementing this approach are susceptible to market timing risks, potentially leading to a wider spread of portfolio outcomes compared to SAA. We therefore believe manager selection is critical in identifying TAA strategies with the highest potential for outperformance given the prevailing market conditions.
