What is tactical asset allocation (TAA)?
An active management portfolio technique known as tactical asset allocation changes the proportion of assets held in different categories to capitalize on solid market sectors or anomalies in market pricing. This approach allows portfolio managers to capitalize on specific market conditions to provide additional value. It is a moderately active strategy since managers restore the portfolio to its initial asset mix after achieving the targeted short-term gains.
Fundamentals of Tactical Asset Allocation (TAA)
One must first comprehend strategic asset allocation to comprehend tactical asset allocation. A portfolio manager may create an investor policy statement (IPS), which outlines the strategic mix of assets that will be present in a client’s holdings. The management will consider numerous criteria, including the necessary rate of return, permissible risk levels, legal and liquidity requirements, taxes, time horizon, and particular investor situations.
“Strategic asset allocation” refers to the long-term percentage weighting assigned to each asset type. The combination of assets and weights in this allocation aids an investor in achieving their particular objectives. Below is a straightforward illustration of a typical portfolio allocation and each asset class’s weight.
- 10% in cash
- Bonds: 35%
- 45% for stocks
- 10% is for commodities.
Tactical Asset Allocation’s Utility
The practice of actively participating in strategic asset allocation and temporarily modifying long-term goal weights to take advantage of market or financial opportunities is known as tactical asset allocation. Let’s take an example where data indicates that for the following 18 months, there will be a significant growth in the demand for commodities. Investors should move additional money into that asset class to capitalize on the opportunity. The portfolio’s tactical allocation may turn into something else, but the strategic allocation will stay the same.
- Money = 5%
- Bonds: 35%
- 45% for stocks
- 15% is for commodities.
Within an asset class, tactical changes are also possible. Assume that the 30% large-cap and 15% small-cap holdings comprise the 45% strategic allocation of equities. It can be a brilliant tactical move to temporarily adjust the stock allocation to 40% large-cap and 5% small-cap if the prognosis for small-cap companies is not promising. This will allow circumstances to alter before long.
Tactical changes often fall between 5% and 10%, although they may go much lower. It is uncommon in practice to make a tactical adjustment of more than 10% to any asset class. This significant modification would reveal a fundamental issue with how the strategic asset allocation was put together.
Rebalancing a portfolio differs from tactical asset allocation. Trades are performed to return the portfolio to the intended strategic asset allocation during rebalancing. For a brief period, tactical asset allocation modifies the strategic asset allocation to return to the strategic allocation when the transient possibilities pass.
Tactical Asset Allocation Types
TAA tactics might be organized or arbitrary. An investor modifies asset allocation in a discretionary TAA based on market assessments of shifts in the same market as the investment. For example, if bonds are predicted to beat stocks for a while, an investor with significant stock holdings could wish to sell these assets. In contrast to stock selection, tactical asset allocation comprises assessments of whole markets or industry sectors. As a result, some investors see TAA as an addition to mutual fund investments.
On the other hand, a systematic tactical asset allocation strategy uses a quantitative investing model to capitalize on transient imbalances or inefficiencies across various asset classes. These changes are based on well-established abnormalities or inefficiencies in the financial markets, supported by practitioner and scholarly research.
Real-World Illustration
In a poll of smaller hedge funds, endowments, and foundations, 46% of participants said they used tactical asset allocation strategies to outperform the market by taking advantage of market moves.
Conclusion
- In tactical asset allocation, long-term goal weights are modified temporarily to take advantage of market or economic opportunities, and an active role is played in the strategic asset allocation process itself.
- Within an asset class, tactical changes are also possible.
- An investor modifies asset allocation in a discretionary TAA based on market assessments of shifts in the same market as the investment.
