Tactical Asset Allocation for Dummies

I was having lunch the other day with the Turnkey PhD and another business school professor, when the conversation turned to Tactical Asset Allocation (TAA).  At this point, this professor, who also happens to have a PhD from Chicago asked, “What is that?”  I realized then that sometimes even those who are otherwise extremely well-versed in finance can be unfamiliar with the term.  So let me try to break it down Barney-style…  

Many people have traditionally felt that if they had their net worth invested in a portfolio consisting of a large number of common stocks, that they were, by definition, diversified.  As the financial crisis that unfolded in 2008 demonstrated, however, there is a significant weakness to this approach, which is that in times of extreme financial distress all the stocks in the portfolio can react in the same way – correlations go to one as they all plummet in value together,  potentially permanently devastating portfolios.  How can an investor protect himself against this kind of financial risk?

 

The key is to invest in asset classes that have low correlations with one another, so that when a given market condition predominates, some asset classes may shine, even as others come under pressure.  Some asset classes zig, as others zag.  For example, it is thought that investing in periods of deflation and recession, it is bonds that offer investors protection.  By contrast, in inflationary environments, hard assets such as commodities and real estate, theoretically can protect investors against a decline in their purchasing power.  Recently,  investors have increasingly sought out the benefits of being invested in foreign stocks which, while correlated with U.S. stocks, are driven heavily by events that are specific to their local markets, and also provide currency diversification.  Indeed, the endowments of major educational institutions have been successfully refining their asset allocation approach for many years.  

Consider the financial challenges faced by the average endowment.  The endowment seeks to grow its asset base over time, but is called upon to  divert a steady, predictable cash flow stream from the portfolio to finance the operations of the institution.   Thus, in addition to its mission of growing its assets, it must also be highly sensitive to the risk of significant capital impairment.   If the portfolio suffers a large drawdown, then it risks putting its operating plans in jeopardy.  The best endowment managers, such as Yale’s David Swenson, manage this balancing act well, consistently growing the asset base, while ensuring that the ongoing cash flow requirements of the  institution can be met without compromising the portfolio, no matter the prevailing market conditions.   This is accomplished by careful  management of the underlying allocations within the portfolio.

“Fine,” you say.  “This all sounds reasonable.  But how am I supposed to determine the appropriate weightings to begin with, and then how do I rebalance these various asset classes going forward?”  Anyone who has sat through the obligatory business school finance classes covering the capital asset pricing model may have some recollections of how one might approach this allocation conundrum, since the theoretical imperative was hammered relentlessly into their heads.  According to most b-school professors, holding the market-weighted portfolio of all assets is the way to go. If you don’t like a ton of risk, simply hold the market portfolio and pair it with some risk-free bond exposure. This all works if you assume investors only care about average returns and standard deviation, you throw in a little Markowitz mean variance mathematics and some assumptions on investor rationality. The tactical asset allocation rule is clear:  investors should seek a value-weighted portfolio of all assets in all markets in the economy.  It is no surprise, therefore, that this is what you hear when you sit in the classroom at business schools today.

Yet is it possible there is another way?  After all, ideally, as financial conditions change, and asset classes within a portfolio fluctuate, investors might hope to tactically reallocate to take advantage of, say, a distressed situation in an asset class that has recently been hammered.  The successful tactical asset allocator might thereby seek to derive a benefit from changes in the underlying market  environment.  But how might you begin to attempt such an outlandish approach that flies in the face of the accepted market orthodoxy?

And that, dear reader, is where Turnkey Analyst comes in, as we have been hard at work researching this very question.  It turns out there has been a sizable body of research over the past several years into how one might hope to make such judgments.  What we are looking for is an approach that will dynamically position us, over weighting us in those asset classes that offer the potential  for significant gain, while simultaneously de-emphasizing those that are likely to generate losses. Is the process perfect? Of course not. Will they definitely work in the future? Who knows. But one thing is certainly clear: holding the “market portfolio” is a sure way to eat 50% drawdowns for breakfast.

Below are some backtest performance results achieved by applying different tactical asset allocation models.  As you can see, the choice of model can have a significant influence on the outcome.