Allowing greater tactical flexibility to actively manage risk exposures across market sectors, rather than simply within them, offers access to a meaningful source of potential performance that has been largely overlooked.
Tactical asset allocation strategies are closely aligned with widely adopted investment principles, but their use in institutional portfolios is surprisingly limited, given the potential benefits. Consider the ways that investors react to changing market conditions but at the same time limit their own flexibility:
- Detailed information on current market conditions and forward-looking expectations is incorporated into setting strategic asset allocations – but usually only once a year.
- Market movements are used as an opportunity to drive portfolio reallocations – but typically result in a rebalancing back to the original strategic benchmark.
- Active management is deployed at the security level throughout portfolios – but tethered to a narrowly defined market benchmark.
The role of skill is therefore concentrated at the most macro (strategic) and micro (security) levels, leaving a vast gap between the two that is filled only by the occasional rebalancing trade. Allowing greater tactical flexibility to actively manage risk exposures across market sectors, rather than simply within them, offers access to a meaningful source of potential performance that has been largely overlooked.
Many institutional investors avoid tactical decision-making because they lack the internal resources and operational flexibility to implement such an approach themselves. In this case, investors can incorporate dynamic tactical asset allocation by partnering with a skilled multi-asset solutions manager. Importantly, this type of external mandate does not diminish the top-down value of the strategic allocation process or the ongoing contributions from bottom-up manager alpha. It is entirely additive.
Experience vs. assumptions
Strategic allocations are not intended to incorporate high frequency adjustments in response to changing markets, nor are they meant to be inert. In practice, most investors adjust their strategic asset allocations infrequently and incrementally, always rebalancing back to the strategic target when market movements have pushed their portfolio sufficiently far away from “home base.”
While there is virtue in this type of patient and disciplined investment process, it makes two critical assumptions: 1) The strategic allocation is effectively “evergreen,” requiring only infrequent and modest adjustments to achieve its long-term objectives; and 2) rules-based “mechanical” rebalancing back to the original target is the best way to realize value from relative movements across markets.
In reality, deviations from expected performance trends can be of sufficient magnitude and duration to reward flexibility (Exhibit 1). This benefit grows with the number of asset classes included in an investor’s allocation. For these reasons, applying a seasoned and sophisticated process of tactical judgment around the exposures to various internal components of strategic allocations has the potential to add significant value.
Returns for stocks and bonds can deviate significantly from long-term expectations
Exhibit 1: Rolling performance of U.S. large cap equities and U.S. aggregate bonds vs. J.P. Morgan Asset Management Long-Term Capital Market Assumptions
Variations against a strategic benchmark
Investors looking to capture the benefits of dynamic allocation strategies can begin by using their strategic asset allocation itself as a benchmark, thereby ensuring that the tactical mandate will be consistent with broader objectives, regardless of whether the long-term goal is total return, a specific risk target or liability risk management. It is also possible to use a tactical strategy to deliver excess returns relative to a specific component of the asset allocation – albeit one that is sufficiently large and diversified to benefit from tactical positioning. For example, an opportunistic liability-driven investment (LDI) strategy can maintain close alignment with liability risk factors while shifting risk exposures across the full spectrum of public, private and synthetic fixed income categories.
The common thread across all three approaches is that the opportunity set must be sufficiently diverse to allow a tactical manager room to shift true risk exposures meaningfully over time. The total return and liability-aware models make use of the full asset allocation spectrum to deliver performance in excess of the benchmark; the main difference is the higher weight to duration in the latter. Opportunistic LDI, while generally constrained to fixed income sectors, still offers a rich and diverse opportunity set across government bonds, credit, securitized assets and private debt.
Risk management, alpha generation and liquidity
As investors balance the need to take more risk in an environment of lower returns, tactical asset allocation strategies can simultaneously help manage risks, add incremental returns and maintain liquidity.
Return-focused investors tend to employ asset allocations that are consistently overweight equities or equity-like risks, while liability-focused investors tend to be concentrated in duration and credit-matched fixed income. Although active managers can generate alpha within these sectors, the broader structural risk concentrations remain in place, often exposing institutions to various forms of tail risk that can be challenging to offset. A key benefit of tactical strategies is their ability to improve performance while embracing a more diversified opportunity set and incorporating cross-market relative value assessments in real time. This allows a nimble tactical strategy the flexibility to mitigate tail risks and take advantage of market volatility rather than be a passive victim of it (Exhibits 2A & 2B).
Illustration of tactical positioning relative to a 70% stock/30% bond benchmark
Exhibit 2A: Relative positioning across equity sectors and overall stock/bond mix vs. benchmark
Exhibit 2B: Relative positioning across fixed income sectors and overall duration vs. benchmark
Further, the excess returns that may be generated in this process are likely to exhibit low correlation to those of bottom-up active managers, increasing the resiliency of the overall strategy. As noted above, the two forms of excess returns are not mutually exclusive; rather, they are complementary.
Historically, institutional portfolios have had a significant bias to liquid public market strategies, which make up the majority of equity and fixed income allocations. However, with current expectations for lower returns in public markets, this bias is likely to lead to a performance gap relative to long-term return targets. Investors are responding with increased allocations to private alternatives, but lower liquidity places limits on this approach, given the operational need for periodic access to capital.
The potential performance differential of a tactical strategy vs. a static beta allocation can be similar to that of private investments vs. public investments
Exhibit 3: 2022 return expectations for comparable public and private asset classes (USD)
The potential performance differential of a tactical strategy vs. a static beta allocation can be similar to that of private investments vs. public investments (Exhibit 3), while offering far better liquidity. Given the highly liquid nature of the underlying asset classes and instruments (funds, ETFs, securities and derivatives), a tactical strategy can be safely scaled up to a level that provides a significant boost to overall returns without imposing restrictions on access to capital.
An efficient solution for managing contributions and rebalancing
Investors often use operational cash inflows and outflows as a crude mechanism to impart some tactical discretion to their investment programs, allocating to “cheap” sectors when inflows arrive and redeeming from “expensive” sectors when capital is needed. In general, these moves will mirror the rebalancing transactions described earlier – backward-looking, limited in scope and tethered to the strategic asset allocation.
A tactically managed sleeve of the portfolio reduces the need for these half-measures. The optimal approach would be to deliver inflows to the tactical manager, who can invest them opportunistically based on the latest market conditions. Should the tactical sleeve reach its maximum size, assets can be redeployed into the public market allocation or alternatives allocation. Outflows for the payment of benefits or institutional support can be drawn from the full liquid allocation, beginning with the public market sectors and including the tactical sleeve, if needed (Exhibit 4).
Inflows can be delivered to the tactical manager, and outflows can be drawn from the public market sectors or the tactical sleeve
Exhibit 4: Illustration of inflows and outflows when using a tactical allocation strategy
Importantly, strategic rebalancing in response to market drift should be managed entirely within the public allocation. Tactical managers may use momentum signals to overweight risk in certain sectors, and this flexibility should be encouraged, not punished. However, the tactical manager should be exempt from rebalancing at the beta level, with the investor relying on the size of the tactical mandate and its guidelines to control excess risk.
Closing the gap
Few investors would deny that setting a strategic asset allocation is an active process, in which all available information about economic and financial conditions is incorporated in a thoughtful exercise that aligns a portfolio with long-term objectives for returns and risk. The effort required to do this well cannot be repeated on a frequent basis, nor should it; there is value in stripping out the noise of day-to-day information and holding to a steady, longer-term course.
Yet the world does not go on pause in between these asset allocation exercises. Avoiding the use of current information in asset allocation is to condone the idea that we cannot make use of that knowledge effectively, or that in the long run it does not matter. But we can use it, and it does matter. The key is finding solutions to the operational constraints that have hampered tactical flexibility in the past.
The role of tactical asset allocation in institutional portfolios has often been limited to the rebalancing process, which preserves the strategic asset allocation as the appropriate target across all time horizons, independent of market conditions. This should change. A strategic partnership with a skilled multi-asset class manager can increase returns, reduce risk concentrations and preserve valuable liquidity.
Patience is a virtue, but so is flexibility. Investors don’t have to choose between them.