Strategic vs. Tactical Asset Allocation

Posted By: Advisor Analyzer Team

Asset allocation is a very long word, so why not break it up into subcategories? Asset allocation is the weighting of one’s investment portfolio among different asset classes, such as stocks, bonds, cash and alternatives. The objective of asset allocation is to optimize a portfolio to provide return and risk characteristics that concur with the investor’s objectives and constraints. It is a key concept in portfolio management, and there are many approaches to asset allocation. Below we’ll discuss two of the more popular versions: Strategic and Tactical allocation approaches.

Strategic Asset Allocation:

Strategic Asset Allocation combines both capital market expectations that is usually derived from a risk adjusted return method such as the efficient frontier and the individual investor’s objectives and constraints from the investment policy statement. It is a long term strategy utilizing “target” weights to create the policy portfolio. Strategic allocation may be used in a shorter investment horizon based on short term capital market expectations which is a direct result of active management.

 

Each asset in the policy portfolio has its own quantifiable systematic risk exposure.  Strategic allocation consciously makes an effort to gain the desired exposures to systematic risk via specific weights to individual asset classes. The proportional weights allow a portfolio manager to effectively monitor and control various systematic risk exposures that is desired by the client.

 

Strategic Allocation responds to the interaction of the investor’s long term investment goals and long run capital market expectations. As the price of investments change, the allocation weights of the portfolio will experience fluctuations as well. Rebalancing a portfolio frequently is costly, and inconsistent with the more long term focus of the strategic approach. Therefore, managers usually set a range that the weights can fluctuate, before any rebalancing is need. This effectively offsets the need to constantly buy and sell positions as they drift from their target weights and reduces transaction costs to the investor.

The main reason strategic allocation is used is to maintain focus on the long term objectives and constraints of the investor and provide discipline for the manager. Without a clearly defined strategic allocation built on systematic factors, it is difficult to assess if the portfolio is accurately reflecting the investor’s desired level of risk and returns.

 

Also, assets generally respond homogenously to systematic (macroeconomic) factors. Therefore, investors can form rough expectations of how their holdings will perform over different interest and market environments in the long run.

Tactical Asset Allocation:

While strategic allocation has a strong focus on disciplined management of systematic returns, tactical asset allocation is more capricious as a result of active management. In active management, the manager deliberately deviates from the strategic asset allocation to take advantage of short term investment opportunities.

 

For example, Google’s tock (GOOG) had a closing price of 331.48 on 1/27/09. Suppose on the following day, Google traded at a price per share of 100.00 for no apparent reason. A manager utilizing strategic asset allocation approach would not bat an eye at the price if GOOG is not part of the policy portfolio. However, a manager utilizing tactical asset allocation would quickly try to capitalize on the mispricing.  If doing so yields superior returns, the manager has generated positive alpha. If GOOG falls further, it may be possible he generates zero or negative alpha.

 

However, as the old saying goes, “there’s no free lunch”. When portfolios are actively managed in efforts to earn excess returns, increases in risk is an unavoidable consequence. While strategic allocation only focuses on systematic risk exposures, (meaning your portfolio should mirror the overall market), tactical allocation must achieve returns that not only compensate for systematic risk, but active risk as well.

Comparison of both approaches:

While tactical allocation provides the potential to experience above average returns, those returns are coupled with higher levels of risk. Empirical studies were conducted to compare the two strategies. Studies show that 94% of the variability of total portfolio returns was explained by strategic asset allocation over the long term. Therefore, the studies suggest that superior returns achieved through security selection and active trading were nominal at best and inferior when operating expenses and transaction costs are taken into consideration. Sometimes, discipline truly pays off.