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Tactical asset allocation is an active management portfolio strategy that moves the amount of open positions in several asset categories to gain the upper hand on pricing anomalies in the market.
The tactical asset allocation methodology allows portfolio managers to establish extra value by taking advantage of specific situations within the market.
Once reaching the desired short-term gains, a portfolio manager will return the portfolio back to its original state – classing the strategy as ‘moderately active’.
Basics Of The Strategy
The concepts of strategic asset allocation must first be understood in order to accurately understand tactical asset allocation.
Investopedia.com describes strategic asset allocation as:
A portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically. The portfolio is rebalanced to the original allocations when they deviate significantly from the initial settings due to differing returns from the various assets.
A portfolio manager may institute an Investor Policy Statement to lay down the strategic combination of assets for inclusion into the client’s portfolio.
The manager will analyse several factors including and not limited to acceptable risk levels, legal and liquidity requirements, time horizon, required rate of return, and unique investor circumstances.
The percentage of the of the investor’s portfolio exposed to each asset class over an extended period of time is referred to as the strategic asset allocation.
The allocation is the culmination of both assets and weights that aid an investor to fulfill their specific targets/goals.
Below is a basic example of the standard allocation of each asset class that might be used to construct an investment portfolio:
- Cash: 15%
- Bonds: 40%
- Stocks: 40%
- Commodities: 5%
Tactical Asset Allocation’s Usefulness
Tactical asset allocation is the process by which an investor takes a moderately active stance on the strategic asset allocation itself as well as adjusting long term target weights for a short period of time – in order to capitalise on the market and its economic opportunities.
That is a very heavily worded definition which can better be explained through another example of asset allocation within a portfolio.
Assume there is going to be a substantial increase in demand for bonds over the next 12 months.
If this is identified by an investor it may be wise of them to shift more funds into bonds to take advantage of this opportunity.
The tactical asset allocation may then become:
- Cash: 15%
- Bonds: 50%
- Stocks: 30%
- Commodities: 5%
As you can infer, tactical asset allocation allows an investor to bring in large short-term profits if their predictions prove wise.
It is critical that detailed research is done to accurately predict which asset class is going to see a rise in the future.
Large losses can be incurred by an investor if the asset classes are allocated a higher percentage and the market takes a downturn.
Typically, an investor will shift no more than 5% to 10% in between each asset allocation.
However, every investor is unique and shifting asset allocation is extremely situational in its nature – no market is 100% predictable.
Shifts that are greater than 10% often reflect a larger problem with the initial construction of the portfolio.
Variations Of Tactical Asset Allocation
Tactical asset allocation methods can be either systematic or discretionary.
If an investor is employing discretionary tactical asset allocation, the investor moves around their allocation according to the same market valuation that their investment is in.
For instance, an investor with a large portion of their assets in stocks may want to move his asset allocation around to accommodate the expected rise of value within the bond market.
Unlike stock picking which requires investors to evaluate specific stocks, tactical asset allocation requires judgements to be made on entire markets or sectors.
It is because of this that investors can perceive the activities of tactical asset allocation as supplemental to mutual fund investing.
Contrastingly, the systematic tactical asset allocation methodology implements the quantitative investment model to take advantage of short-term imbalances amongst different asset classes.
Fun Fact
In a survey of small hedge funds, endowments, and foundations – 46% of respondents were found to implement techniques consistent with tactical asset allocation to play the market by riding market trends.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
