Tactical asset allocation (TAA)
strategies gained in popularity in
the 1980s, particularly after
adding value following the 1987
equity market crash when many
processes had signalled a shift out of
equities earlier that year. However,
the strategy fell from grace in the
1990s, mainly because its patchy performance
failed to match up to markets
that headed relentlessly upwards.
TAA’s reputation was not helped by
its use as a total portfolio overlay by
some pension funds that adopted it.
This meant that the TAA manager
had the unenviable potential to
depress returns across the entire fund.
But with hindsight, pension funds
that ran out of patience with their
TAA programmes probably did so at
just the wrong time in light of subsequent
performance. In recent years,
some TAA managers have added significant
value, putting TAA firmly
back on the radar screens of
investors. Instead of being a 1980s
has-been, TAA has taken on a new
lease of life as more managers enter
the business and existing processes
have developed.
The markets certainly appear more
favourable to TAA strategies, which
aim to switch between one asset class
and another (or from one market to
another within the same asset class)
in search of superior returns. More
volatile conditions since markets
peaked in 2000 have tended to suit
TAA managers, as volatility
increases return differentials
between asset classes, offering more
opportunities to profit.
At the same time, TAA managers
have gone global, providing them
with more opportunities and more
sources of alpha to draw on. For
example, currency has been a star
performer in recent years. In its earliest
incarnation in the US, by contrast,
managers simply switched
between domestic stocks, bonds and
cash. No longer relying just on valuation,
TAA managers have also
increased the use of factors, including
economic and technical ones.
Most of the strategies are now
model-driven to try to cope with
these additional complexities of taking
global markets and additional
factors into account. This increased
breadth (number of decisions) of
factors should reduce the likelihood
of episodic performance, but is
unlikely to protect investors from
equity market crashes as the equity
versus bond decision represents a
relatively small part of the risk taken
in most processes.
Another development of particular
interest for pension funds is that
TAA managers are launching pooled
funds to make their products more
accessible. About six have been
launched so far, and more are in the
pipeline. Pooled funds make investing
in a TAA strategy much more
convenient. Instead of holding
derivatives (with all the accompanying
problems of posting margin, and
the documentation required) a pension
fund simply invests in units in
the pooled vehicle, and tracks performance
by looking at the fund’s
net asset value. There is also the
added attraction of limited liability if
a TAA fund does experience problems.
The risk will be carried by the
prime broker (or manager) of the
fund and not by the client.
All these factors make TAA more
attractive for institutional investors,
although not necessarily as a total
portfolio overlay. The main disadvantage
is that it can eat up a disproportionate
slice of the risk budget.
Instead, TAA has earned a more
valid place alongside other alternative
assets, such as hedge funds and
private equity, in the ‘return seeking’
part of the pension portfolio.
TAA is one of what we would term
‘skill-based’ strategies that rely for
return on manager forecasting skill
rather than rising markets.
In fact, TAA programmes look
similar in some ways to macro hedge
funds, and certain managers are
offering their TAA pooled funds to
funds of hedge funds. However,
macro funds and TAA funds are by
no means the same animal. Some
macro funds are more trend-following,
take bigger bets, operate in the
physical as well as the derivatives
markets, are far less transparent, use
varying amounts of leverage and different
methods of risk control.
Despite a make-over, the new
look TAA is not without its
drawbacks. One of the main
problems is the relatively small number
of managers who offer broadbased
global strategies. Many managers
have laid claim to being TAA
providers, although not all of them
have the appropriate mix of
processes and ability to cope with
the complexity of today’s markets.
Another drawback is the limited
performance history of TAA programmes,
especially given their significant
changes during the last five
years. Comparing performance
across TAA managers is notoriously
tricky as they often operate with different
benchmarks, constraints and
tracking errors, although pooled
funds that have recently been
launched should make this comparison
easier in the future.
When looking at this asset class it
is important to consider return
expectation given TAA programmes’
relatively volatile past.
What can be expected going forward?
Information (return/risk)
ratios for some TAA managers have
been in the range 0.5-1.0 (or
higher). However, a reasonable
gross information ratio expectation
might be 0.5 (which is generally
higher than for a conventional
equity manager). There is some evidence
that returns will be more limited
as inefficiencies are arbitraged
away, however opportunities exist in
currencies, and in the emerging
markets, for instance. A number of
managers are also adding active
commodity as well as sector and
duration strategies to their model
capabilities in order to continue to
increase breadth.
To ensure that TAA managers are
able to apply skill to its full extent, they
should not operate with significant
constraints. In an ideal world, the
structure of the mandate would
include as many assets as possible to
increase breadth. Control ranges
would be symmetric, allowing both
long and short positions. As with currency
mandates, the preferred
approach would be to set an overall risk
target and allow managers reasonable
levels of flexibility within which to
achieve their performance target.
The pressure is on trustees and
their sponsors to consider the best
investment options that would both
diversify risk and help reduce deficits
in this low return environment. As
markets have become more global
and increasingly characterised by
volatility, funds ought to position
themselves in such a way as to take
advantage of short-term investment
opportunities while still maintaining
a focus on meeting long-term
liabilities. Therefore subject to the
risk profile of the fund and having a
suitable governance budget (or inhouse
skills), the newly evolved
TAA, treated as a skill-based asset
class in the portfolio and managed
by a skilful manager, probably warrants
a good look.
Robert Brown is a senior
investment consultant at Watson
Wyatt

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