Strategic asset allocation (SAA) determines long-term exposure to systematic risk aspects. However, the present changes in monetary policy in lots of industrialized and emerging countries in addition to the phase of the economic cycle require tactical considerations.
The tactical overlay strategy is meant to generate added value by temporarily deviating from the weights assigned within the SAA process. Let me explain.
The message is evident: asset allocation matters.
But in terms of the asset allocation process, we want to distinguish SAA from Tactical Asset Allocation (TAA). SAA combines the long-term capital expectations of varied asset classes with an investor’s return objectives, risk tolerance and constraints. Based on this, the exposures within the permitted asset classes are determined. The result’s a set of portfolio weights for the asset classes. This is named strategic asset allocation or policy portfolio.
SAA should represent the reward for taking systematic risk, that’s, risk that can not be diversified away. In other words, returns are derived from systematic risk exposures within the SAA. The SAA serves as a benchmark that specifies the suitable asset mix from a long-term perspective.
TAA is predicated on the deviation of expectations from the long-term and the perception of imbalances. SAA is derived from long-term capital market expectations as described above. The TAA exploits the deviation of asset class values ​​from the expected long-term relationship.
TAA decisions are based on the position of assets within the business cycle in addition to expected inflation, changes in central bank policy and fluctuations within the riskiness of assets. Regarding the previous, fluctuations within the business cycle play a key role in terms of TAA. It matters whether the present phase of the cycle is a boom or a recession. Once it is set which asset class is currently trending, the sub-asset classes could be analyzed in additional detail. Valuation, economic data in addition to technical and sentiment variables are crucial.
Tactical overlay strategies provide particular flexibility as ultra-loose monetary policy involves an end in much of the world. The easy money era led to high valuations within the stock and bond markets: a standard discount rate shock may very well be what capital markets need for the normalization process to start. Therefore, a coherent TAA process can exploit variations in expected long-term returns and perceived imbalances.
Therefore, tactical asset allocation is a source of risk tracking, with the SAA serving as a benchmark. However, in “Tracking error and tactical asset allocation“Manuel Ammann and Heinz Zimmermann show that lively management throughout the asset class represents a greater source of risk in relation to the SAA than the TAA. Nevertheless, the expected advantages of TAA must even be weighed against the prices of tactical adjustments.
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Photo credit: ©Getty Images / Thomas Barwick
