Has tactical asset allocation (TAA) disappeared? TAA – taking advantage of short-term anomalies in the relative values of assets – has been significantly eroded in pension fund investment structures. Although it is still present within portfolios at a very modest level.
In past times UK pension funds funds chose the average of their peers as their benchmark. This effectively, but possibly implicitly, anchored their strategic asset allocation in relation to other funds. The fund was then managed by one or more multi-asset (balanced) managers, depending on size, who were given very considerable discretion over asset allocation and stock selection.
TAA disappeared as more evidence became available that this activity was almost never a source of consistent added value, let alone at a significant level. It became increasingly evident that stock selection – particularly in the largest asset class and market, usually domestic equities – was the dominant driver of relative, to benchmark, performance.
In the UK, WM data shows the dominance of stock selection in explaining relative performance, for example, in the 1993–95 period its contribution was 69%; in 1996–98 62%, and in 1999–2001 82%.
The demise of balanced management and the growth of specialist structures demanded a different approach to sourcing added value from TAA. The route normally chosen was to appoint a stand-alone TAA manager, either top-down fundamental value or quant-driven. When neither of these proved satisfactory, the search for added value (alpha) moved emphatically to more predictable and reliable sources, particularly stock selection.
Was TAA’s death premature?
The first mitigating factor is the investment market environment during the time that TAA ‘failed’. Equities were enjoying one of their most sustained bull markets in history. Bonds too were responding very favourably to the ‘new paradigm’ macro-economic conditions of low, and stable, inflation and interest rates. The result was modest investment return differential between major assets and consequently less opportunity to add value through TAA. The increasing globalisation of equity markets – demonstrated by rising correlations – also limited opportunities to add significant value from market pricing anomalies. TAA by its very nature depends on asset mis-pricing, manager capability of identifying and responding and – crucially – the mispricing to be corrected. The latter was little evident during the equity-bond bull phase of the 1980s and 1990s. Ironically, when asset mispricing was finally exposed in early 2000, TAA barely existed.
The second factor, which has hastened the demise of TAA, is a technical feature inherent in most scheme-specific benchmarks. These are usually rebalanced according to some time frame, normally quarterly. The benchmark has therefore inherent TAA according to the investment dictate that assets which have performed relatively strongly are sold and assets which have underperformed are purchased. ‘Sell relatively high, buy relatively low’. And these asset allocation shifts are made free of cost in the benchmark. A rebalanced benchmark is therefore a powerful adversary for any active TAA manager.
The third factor is that managers are given only modest discretion to exercise their TAA judgement. Indeed tight asset allocation constraints, together with the increasingly common annual downside limit on relative performance, act as powerful barriers to TAA.

Why is there now such a focus on strategic asset allocation?
Ironically one of the major catalysts of a reappraisal of strategic asset allocation has been a short-term, tactical, event – the unwinding of overvalued equity markets. Another catalyst was the Paul Myners review of UK institutional investment, which recommended a significant increase in the resource devoted to – and cost paid for – strategic asset allocation.
Many studies have suggested that 80-90% of a fund’s return comes from asset allocation. It is more important – from a fund investment perspective – to pick assets and markets, rather than securities within an asset or market. The reverse applies to a portfolio manager.
In the UK the decision, and subsequent implementation, by the Boots pension fund to liquidate its equity holdings and replace them with corporate bonds questioned conventional equity-biased investment. In so doing, this raised awareness of strategic asset allocation. I doubt if there is a single pension fund in Europe which has not debated its strategic asset allocation in the last year or two. Although the debate may not necessarily have led to a materially different outcome.
For example, the chart shows the link between UK pension fund maturity and exposure to real assets (equities + property). Although there is some correlation, as given by the regression line, more striking is the commonly high exposure to real assets across the maturity spectrum.

Is balanced management making a comeback?
This is a reference to the new vogue for linking strategic asset allocation to liabilities. Although a considerable number of funds would rightly object to this insinuation.
While there are an increasing number of countries and an increasing number of suppliers offering bonds which provide price inflation protection, there are not generally available assets which adequately protect against liabilities increasing mainly as a result of earnings inflation. As such there is no commonly understood asset strategy which could be considered either risk-less or minimum risk. Thus any strategic asset allocation is a consideration of risk and return, which only the investor can decide.
It can be argued bonds are a lower risk asset for pension funds, certainly in the short-term – discontinuance or any other short-term solvency or accounting standard. It can equally easily be argued that in terms of future employer contribution level or funding level, the risk of not being exposed to equities is unacceptable. The greater stability of employer contribution level on higher bond exposure may be of little solace to a fund which cannot afford the pension scheme at all unless it captures the equity risk premium. While this premium is being forecast as considerably lower in future, I have yet to hear serious investment professionals suggest it will not exist.
One problem with the idea that asset managers take on the responsibility for a dynamic liability-led asset allocation is that they cannot also take on the accountability which remains firmly with the fiduciaries. In modern fund structures with heavy exposure to specialist management, no one portfolio manager can be an effective ‘lead’. The very popular core-satellite approach effectively precludes total fund dynamic asset allocation, unless through an overlay TAA manager!

Are ‘new’ assets, such as alternative investments, the answer? And, if they are, what question do they answer?
Alternative investments are basically private equity, hedge funds and high yield bonds. Property has always been a main stream asset, even if its exposure in some funds has became minimal. It could reasonably be argued that private equity is another form of equity, with a higher risk-return profile and high yield bonds are another similar form of bonds. There may well be risk diversification benefits of having less-correlated assets along with mainstream equity and bonds.
The only ‘new’ asset is therefore hedge funds, put forward as absolute return or targeted return strategies, say aiming for an annualised return of cash+5% pa, or 8% pa with low volatility. However, it is difficult to see how this links assets more directly with liabilities. Pension fund liabilities do not normally display this type of growth profile. I am concerned that a disproportionate part of their current attraction is their positive return in a period of disappointing negative fund returns. Will they still be attractive if, and when, funds are achieving decent equity returns? Although sold for diversification, they may be being bought for return.
So what next?
You are responsible for the investment strategy of a pension fund, currently 85% funded on an ongoing basis, with the sponsoring employer paying a contribution of 20% of salary roll. Would you bet on equities to improve the funding and keep employer costs down, albeit with potentially greater volatility around these ‘risk’ factors, or back bonds with lower volatility around these risk factors but at the expense of lower funding and/or higher employer costs?
Eric Lambert is head of performance at consultancy The WM Company in Edinburgh

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