Tactical asset allocation (TAA) involves deliberately underweighting or overweighting asset classes relative to their target weights in the policy portfolio in an attempt to add value. TAA is active management at the asset-class level. Thus in a top-down perspective, TAA would follow the strategic asset allocation decision and stand one level above decisions about how to manage money within an asset class.





Tactical asset allocation can be conducted indepen­dently of the within-class investment decisions by using derivative securities, a cost-efficient means for changing asset-class exposures. In that case, TAA can be described as an overlay strategy.


TAA is based on short-term expectations and perceived disequilibria. We know from prior discussion that strategic asset allocation reflects the investor's long-term capital market expectations. That concept is logical because strategic asset allocation concerns meeting the investor's long-term objectives. The investor's short-term views may well differ from his long- term views, however. Tactical asset allocation involves tactical bets to exploit those differences. Economically speaking, it seeks to exploit transitory deviations of asset-class values from their expected long-term relationships. An investor may make occasional tactical weight adjustments in some circumstances or may have an ongoing and more systematic program of tactical adjustments. Both can be described as tactical asset allocation. TAA can be managed in-house or delegated to one of the many professional investment managers who run TAA programs ( proportional reinsuranceypes ).


Tactical asset allocation is frequently based on the following three principles:

1. Market prices tell explicitly what returns are available. Cash yields reveal the immediate nominal return accorded short-term investors. The yield to maturity of T-bills is the nominal reward for holding them to maturity. Thus, at least for this and similar pure discount instruments, investors have objective knowledge of prospective returns. Although prices yield less direct information about prospective return for other asset classes, we can at least make educated estimates. For example, we could use dividend yield plus growth rate to estimate the return to equities. Inevitably, reality will not quite match these expectations. Nevertheless history suggests that simple objective measures provide a useful, objective guide to future rewards.

As an illustration, Exhibit 5-49 demonstrates one method for constructing return expectations (many others are in industry use as well). Almost any investment we might choose has three components to return: income, growth in income, and changing valuation levels (changes in the value that the market assigns to each dollar of income). For the last 77 years, U.S. stocks delivered a real return, over and above inflation, of nearly 7 percent. This return consisted of 4.2 percent from yield, a growth rate in dividends that was 1.2 percent above the rate of inflation, and 1.5 percent from a tripling in the price/dividend ratio (a 70 percent decline in dividend yields). Looking to the future, can we count on continued expansion in the price/dividend ratio? Doing so

EXHIBIT 5-49 Long-Term Return Attribution for U.S. Equities


January 1926-September 2003

As of September 2003

Average dividend yield



Growth in real dividends



Change in valuation levels80



Real stock return



Less average real bond yield



Less bond valuation change81



Real bond return



Return differential



80Yields went from 5.1 percent to 1.6 percent, representing a 1.5 percent annual increase in the price/dividend valuation level.

81Bond yields fell during this period, and real yields on reinvestment were also poor during much ofthis span.

would be dangerous, because the ratio could as easily go the other way. Can we count on 4.2 percent from income? Not when the current market yield is 1.8 percent as of this writing. This method thus suggests a 3 percent real return as one possible starting point for expectations of U.S. equity returns.

2. Relative expected returns reflect relative risk perceptions. When investors perceive more risk, they demand payment for assuming it. If expected equity returns are particularly high compared with bond expected returns, the market is clearly according a substantial risk premium to stocks. It does so when investors in general are uneasy with the outlook for stocks. In the 20 years following the deepest point of the Great Depression of the 1920s, equity dividend yields were significantly higher than the yields on bonds. Apprehensive of a replay of the depression, stockholders demanded a compensatory premium. Ultimately, the markets rewarded those investors willing to bear equity risk. Conversely, as recently as 1981, demoralized U.S. bond investors priced those securities to reflect their unprecedented volatility amid fears of rebounding inflation.

In the mid- to late 1990s, investors embraced the concept that stocks had little risk when measured over the long-term, which lowered their perception of equity risk. Many investors greatly increased their stock holdings without regard to their investment time horizons. As stock prices rose and the risk premium of stocks declined, so the prospects of future rewards from stocks declined as well. The subsequent bursting of the stock market bubble in March 2000 was merely the effect of the market reestablishing an appropriate risk premium for what is still the riskier asset class.

Exhibit 5-50 illustrates the link between risk and reward in U.S. markets for the last 30 years. It shows how the risk premium that is delivered for investing in stocks rather than bonds varies through time, in line with the relative volatility of stocks over bonds. The volatility is calculated as the mean absolute deviation of global stock total returns divided by the mean absolute deviation of global bond total returns during the prior five years.

EXHIBIT 5-50 Volatility Ratio vs. Equity Risk Premium


In 1988, the global equity risk premium dipped below normal levels and remained low for most of the next decade. At the same time, the global volatility ratio rose, and these two measures diverged until the volatility and risk premium again converged in



the mid-1990s. In the long term, these measures tend to track one another. In the short term, they provide information when they diverge.

If relative expected returns reflect relative risk perceptions and those perceptions do not have a solid economic basis, overweighting the out-of-favor asset class can be fruitful. To illustrate such an analysis, the period just subsequent to the end of 2003 saw the volatility ratio rise in line with, albeit somewhat faster than, the equity risk premium. This implies that the equity risk premium, although still high by historical standards, may be at least partially explained by a higher than usual volatility ratio, and hence it is not as bullish an indicator for equities as it would be otherwise. The equity risk premium is best viewed in the context of the relative risk of global markets, not in isolation.

3. Markets are rational and mean reverting. If the Tactical asset allocation manager can identify departures from equilibrium in the relative pricing of asset classes, the manager may try to exploit them with knowledge that departures from equilibrium compress a proverbial spring that drives the system back towards balance. If 6 percent bonds produce zero return over a certain year (by declining in price enough to offset the coupon), they then offer a higher yield in subsequent years to a prospective holder. Because this process is inherently finite, these bonds, short of default, will eventually produce their promised returns. Bond price changes, moving cyclically, exhibit negative annual serial correlation, a characteristic prized by contrarian tactical asset allocators.

In the same way, differences between expected return on equities and realized return persist over time, but only if earnings growth estimates are inaccurate. They typically are inaccurate, of course, but the law of large numbers provides more confidence in estimating returns of asset classes than individual securities. Similarly, aggregated reported earnings are more meaningful than earnings reported on a company-by-company basis, because the most egregious earnings manipulations are tempered by results from more-truthful peers. Similar to bond yield for bonds, earnings yields on stocks provide an effective (if approximate) valuation measure of future stock returns.

The above three principles address the returns that an investor may expect the markets to deliver when they function rationally and tend toward fair value. The suggested tactical asset allocation decisions were contrarian in nature. The tactical asset allocator should be aware that if a rule for trading leads to superior performance, investors on the losing side of the trades may eventually stop playing; market prices will then adjust to reflect changes in supply and demand, and a trading rule may cease to work. Furthermore, the tactical asset allocator should be aware that deviations from fair value based on historical analysis could persist if the economic environment has changed. Factors such as

  • changes in assets' underlying risk attributes,
  • changes in central bank policy,
  • changes in expected inflation, and
  • position in the business cycle

need to be considered in evaluating relative valuations, because they can either mark changes in return regimes or otherwise explain current pricing. A U.S. TAA manager (managing a mix of U.S. stocks, U.S. bonds, and cash) might specify one weighting of relative value
and business cycle variables during periods of expansionary Federal Reserve policy (indicated by Fed discount rate decreases) and another weighting during periods of restrictive Fed policy. Fed policy changes could mark periods in which the relationships between stocks and bonds differ. Besides relative value and business cycle variables, some Tactical asset allocation managers use technical/sentiment variables in assessing future asset-class prospects. Price momentum is an example of a technical/sentiment indicator. It is not contradictory that an asset could exhibit momentum at a short time horizon and mean reversion at another, longer, time horizon.

Risk and costs deserve close attention. TAA may decrease or increase the absolute risk level of the investor's overall portfolio, depending on manager skill, the type of TAA discipline involved, and the direction of markets during the time period considered. Relative to the strategic asset allocation, however, Tactical asset allocation is a source of tracking risk. To manage that risk, in practice, TAA managers often are limited to making adjustments within given bands or tactical ranges around target asset-class weights. As an example, the tactical range could be the target weight ± 5 percent or ± 10 percent of portfolio value. With a ± 10 percent tactical range and a 60 percent target for equities, the TAA manager could weight equities within a range of 50 percent to 70 percent. At least one study has found that within-asset-class active management is a much greater source of risk relative to the strategic asset allocation than the selection of tactical weights.

Tactical asset allocation must overcome a transaction-costs barrier to be advantageous. The potential benefits of any tactical adjustment must be examined on an after-costs basis.

EXHIBIT 5-51 Total Return Expectations for Asset Classes

Asset Class



Global equities



Canadian equities



U.S. equities



European equities



Global fixed income



Canadian bonds



U.S. bonds




GUE runs a top-down global tactical asset allocation program that first looks at the overall allocation between global equities and global fixed income, and then at the asset allocation within global equities and global fixed income. Assume that the risk characteristics of asset classes are constant.

    1. Calculate the long-term and short-term return expectations for global equities (A and B, respectively) and global fixed income (C and D, respectively).
    2. Determine and justify the changes in portfolio weights (relative to the policy portfolio target weights) that would result from a global tactical asset allocation program.

Solution to Problem 1: Canadian equities, U.S. equities, and European equities represent respectively 30%/70% = 0.4286,30%/70% = 0.4286, and 10%/70% = 0.1429 of global equities. Therefore, for global equities,

A = (0.4286 x 10%) + (0.4286 x 8%) + (0.1429 x 7%) = 8.7143%, or 8.71% B = (0.4286 x 12%) + (0.4286 x 8%) + (0.1429 x 7%) = 9.5714%, or9.57%

Global equities' short-term expected return at 9.57 percent is above the long-term expectation of8.71 percent because Canadian equities are expected in the short term to outperform their long-term expected return. Canadian bonds and U.S. bonds represent respectively 20%/30% = 0.6667 and 10%/30% = 0.3333 of global fixed income. Therefore, for global fixed income,

C = (0.6667 x 5%) + (0.3333 x 5%) = 5% D = (0.6667 x 6%) + (0.3333 x 3%) = 5%

Global fixed income's short-term expected return at 5 percent equals its long-term expectation. Within global fixed income, however, Canadian bonds are expected short- term at 6 percent to outperform their long-term expected return while U.S. bonds are expected short term at 3 percent to underperform their long-term expected return.

Solution to Problem 2: The results in Part 1 suggest three actions:

• Because global equities appear undervalued compared with global fixed income in the short term, increase the weight on global equities from 70 percent and decrease

the weight on global fixed income from 30 percent. The justification is that the short-term expected return on global equities is higher than its long-term expectation, while the short-term expected return on global fixed income is unchanged from its long-term expectation.

  • Within global equities, overweight Canadian equities versus their target weight of 30 percent and decrease the weight on U.S. and European equities. Although the short-term expected return on U.S. and European equities are unchanged from their long-term expectations, Canadian equities are expected to outperform short term.
  • Within the new global fixed-income allocation, overweight Canadian bonds and underweight U.S. bonds, reflecting their short-term expected performance.

EXAMPLE 5-22 A Tactical Asset Allocation Decision

William Davenport is the chief investment officer of an endowment that is invested 45 percent in U.S. equities, 15 percent in non-U.S. developed market equities, and 40 percent in U.S. Treasury Inflation-Indexed Securities (often called TIPS). The endowment annually reviews its strategic asset allocation. Its IPS authorizes tactical ranges of ± 10 percent in each asset class. Based on his own past observations and his reading of the investment literature, Davenport believes the following:

  • U.S. monthly equity returns are less sensitive to the U.S. business contractions than monthly equity returns in European markets and Japan. That is, in U.S. recessions, U.S. equities' returns may actually be relatively better than equity market returns in Europe and Japan.
  • An increase in the yield of a 1-year Treasury note indicates a decrease in the probability of a recession in one year's time.

Based on a decrease in the yield of U.S. 1-year T-notes, Davenport has suggested a 55/5/40 U.S. equities/developed market equities/TIPS tactical asset allocation.

    1. Evaluate whether the recommended tactical asset allocation is feasible.
    2. Appraise the logic of the recommendation.
    3. Evaluate the additional information that should be considered before adopting Davenport's recommendation.

Solution to Problem 1: Davenport's TAA suggestion is just within the tactical ranges allowed by the endowment's IPS. Therefore, the suggestion is feasible.

Solution to Problem 2: IfDavenport's beliefs are correct, the decrease in the T-note yield indicates an increase in the probability of a U.S. recession in one year. If a recession occurs, he expects U.S. stocks to outperform non-U.S. equities. Therefore, shifting funds from non-U.S. to U.S. equities is logical.

Solution to Problem 3: The following information should be assessed:

  • The costs of the tactical adjustment in relation to the expected benefits.
  • The increase in tracking risk and the change in expected absolute risk in relation to the expected benefits.
  • The economic logic of Davenport's beliefs. If they have an economic logic, it is more likely that relationships based on past observations will hold for the future.
  • The strength of the expected relationships. Davenport is suggesting making the maximum permissible allocation to U.S. equities. After the adjustment, the portfolio may be less well diversified than previously. Is the size of the bet justified?
  • The presence of any factor such as a change in the risk attributes of assets that may make past relationships fail to hold in the future.


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