Tactical Asset Allocation Can Be Successful With The Right Model

Includes: DIA, QQQ, SPY
by: Roman Chuyan, CFA

An interesting new white paper written by Alexander Melnikov, PhD., Professor of Mathematical Finance at the University of Alberta speaks to the relationship between alpha and "information coefficient" (IC), as defined by Grinold and Kahn:

"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% of a typical balanced stock-bond portfolio risk and return comes from Policy asset allocation - see Brinson et.al. (1986, 1991), Ibbotson & Kaplan (2000). Clearly, potential for adding value through actively managing asset allocation is greater than from active security selection. However, while active security selection is widely practiced, tactical asset allocation (TAA) 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 U.S. and global equities). Several requirements to the investment process stem from this definition. First, the responsibility for TAA must be placed with the group within the investment organization that spans across asset classes - typically the office of the Chief Investment Officer. 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."

From our own experience working with institutional investment managers (mainly pension funds and endowments), many of them already attempt actively managing their asset allocation, though it is usually not explicit. This is not surprising given the large implications to their performance. You may hear this in your investment strategy meeting: "We want to be positioned defensively due to anemic economic recovery in the U.S." (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.

Prof. Melnikov further explains that in order to successfully implement TAA, investors need "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 (1999). The authors establish the following relationship between active return (alpha) and forecasting skill, or information coefficient (IC):

α = σ × IC × Score

The key to achieving good performance from TAA, therefore, is the skill (IC) of forecasting asset class returns."

We note that "Tactical" in TAA does not mean "short-term", high portfolio turnover or high trading costs. In fact, accurate return forecasting should give only one or two significant Buy or Sell signals a year, on average.

The most efficient way to implement TAA positions for an institutional investor is by establishing the desired long or short notional exposure through equity index derivatives, such as S&P 500 futures. For example, suppose the model forecasts a strong return for equities, and the manager wants to be overweight equities relative to benchmark by 10%. They would then simply buy the needed amount of S&P 500 futures.

Individual investors and smaller family offices who don't transact in derivatives can use ETFs to implement TAA. In the above example, the investor may have cash and short-term bonds in his portfolio, which he can cost-efficiently sell and invest the 10% in liquid index ETFs such as SPY, DIA or QQQ.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.