Building your tactical asset allocation strategy

While some institutional investors are constantly adjusting their asset allocations in the hope of improving performance or reducing risk, the majority of defined benefit schemes focus instead on longer-term, strategic asset allocation.

They are quite right to do so. Leading academic studies consistently demonstrate that the strategic asset allocation of a portfolio is responsible for the vast majority of its returns.

One study, conducted by Wolfgang Drobetz and Friederike Köhler, found that strategic asset allocation was responsible for 134 per cent of the returns of 51 German and Swiss funds from 1995 to 2001.

This seemingly bizarre result can be explained by the fact that poor stock selection had significantly damaged performance – which is why asset allocation contributed more than 100 per cent to performance.

Schemes can simply avoid the problems faced by the subjects of Drobetz and Köhler’s study by investing passively in index-tracking funds. But there is no such thing as a passive asset allocation.

Scheme investors may only review their asset allocation periodically, but it is being tested every day the markets are open. So a strong investment governance framework should also involve continual asset allocation monitoring.

Tactical or dynamic?

Step one in designing a governance structure that involves more active asset allocation is determining how frequently asset allocations should be reviewed and potentially changed.

Schemes are not hedge funds and should not be attempting to make high frequency tactical switches. But, as with everything, there is balance to be found.

For schemes with access to dedicated investment resources, a format that can work well is daily market monitoring, more detailed weekly portfolio reviews and formal monthly asset allocation sessions.

Some institutional investors have monthly rebalances. These approaches may only generate a handful of changes a year, depending on circumstances, but they can make a big difference. Some might consider this approach dynamic rather than tactical.

An approach that can work well for committees is to set parameters around strategic asset allocation that are changed dynamically as the outlook over the next 12 months changes for each asset class.

The work that goes into forming one-year outlooks can be complex, taking account of the latest economic and market data, using in-house and external research and analysis, developing proprietary ranking and risk management systems.

But the way investment views are organised should be straightforward. A simple traffic light system – red for negative, green for positive, amber for neutral – would help the trustees to decide when to shift asset allocations and by how much.

The danger is to do too much too quickly and reverse decisions before they have had time to take effect, piling up trading costs. Trustees should not be too quick to adjust their outlooks, but they should be swift to act once a clear decision has been made.

Liquidity matters

Pension trustees often believe that, as long-term investors, the ability to sell or buy an asset quickly – liquidity – does not matter. 

It is certainly the case for illiquid alternative investments like physical property and hedge funds, where long-term investors who do not require liquidity have an advantage over the rest of the market.

But equities and bonds are, on the whole, highly liquid assets. Trustees who invest in illiquid pooled funds to access liquid equity and bond markets are not benefiting from illiquidity in the same way. 

When it comes to dynamic asset allocation, liquid investments are a must. That is why institutional investors of all types are now using exchange-traded funds.

Like traditional pooled passive funds, ETFs can be bought or sold within minutes, are highly transparent and low-cost.

While trustees may not need such a high degree of liquidity, ETFs are extremely practical and there is no need for a delay between making an asset allocation decision and implementing it.

Dynamic asset allocation, if managed and carried out appropriately, can significantly improve risk management and also performance. But derisking is also a form of tactical management, involving large-scale asset allocation shifts taken step by step.

Defined benefit pension schemes make tactical decisions of one type or another more frequently than they realise – the question is whether trustees have established the tactical strategy that is right for their scheme.

Bob Campion is institutional business director at Charles Stanley Pan Asset