Explaining tactical allocation

Should investors chisel their portfolios onto granite and wait them out for the long haul, regardless of what happens in the markets on a monthly, quarterly or yearly basis? Or should money managers take a more flexible approach to the way they slice up their clients’ asset class percentages? Two top portfolio managers answer this question by explaining the difference between strategic and tactical asset allocation, and how and when to employ the latter.

Strategic vs. tactical

Let’s say you’ve assessed your client’s risk tolerance and investment goals for the next five or ten years, and on this basis constructed a portfolio with 60% invested in equities and 40% in bonds.

This is the client’s strategic asset mix, also referred to as the strategic baseline or neutral weight. The term strategic is used because the portfolio’s asset mix represents a plan of action for achieving a certain level of growth over a longer time horizon, says Geoff Stein, portfolio manager in the Global Asset Allocation Group at Fidelity Management & Research Company.

But a lot can happen between the inception of the portfolio and the end of the ten-year period that defines the time horizon the client’s investment goals are pinned to. This is where tactical asset allocation comes into play.

“Tactical asset allocation refers to the flexibility you bring into the process of deploying capital,” says Stein. “Advisors shift money on a shorter-term basis — a period of weeks or months — between different asset classes. Any temporary shift away from your long-term neutral would be a tactical position.”

“It allows portfolio managers to create extra value or incremental returns by taking advantage of anomalies in the marketplace,” says Sarah Riopelle, senior portfolio manager, investment solutions at RBC Global Asset Management.

There are prudent limits, however, to how far the portfolio’s strategic goalposts should be moved around. Stein says a maximum shift of plus or minus 15-20% for any given asset class is the norm.

Riopelle pegs the limit at 15%, and notes it is seldom reached. “There would have to be fairly extreme circumstances in the market to get us to that point, and even then we would need to believe that those circumstances have not yet been reflected in market prices,” she says.

How it’s done

The decision to make a tactical adjustment is based on an assessment of a sea of variables, indicators and inputs that fall into four main categories:

• The macroeconomic picture
• Bottom-up fundamentals of different asset classes
• Valuations
• Investor sentiment

Getting a handle on the macroeconomic picture involves determining which phase of the business cycle is in play, and when the next will likely occur.

“Based on that, you have a cookbook for the asset classes you want to be emphasizing,” Stein says.

During the early and middle stages of an economic cycle — the recovery and expansion periods — you want to gravitate towards riskier assets like equities, credit, corporate bonds, high-yield bonds, emerging markets and commodities, Stein explains.

Once the more mature phase of the cycle is reached, where growth has levelled off or begun to dip, you want to start pulling the risky assets off the table and move towards lower-risk asset classes such as cash or fixed income.

“That’s the basic template,” says Stein. “Then you factor in variables like inflation and interest rates to get an even more specific flavour for the way you would want to be invested.”

Bottom-up fundamentals relate to the outlook for corporate profitability and cash flow, company dynamics within industry sectors, and the creditworthiness of bond issuers.

Valuation involves evaluating whether various asset classes are priced either rich or cheap. This may entail indicators such as stock P/E ratios, bond yield spreads and other price measures.

Finally, market sentiment measures can be useful contrarian indicators and point to a tactical shift. For example, when sentiment surveys and put-call ratios show extremely high levels of bullishness, it may be advisable to take a tactical position to reduce risk.

Conversely, when the data show extreme bearishness on equities, it may be a contrarian indicator for tactically adding riskier asset classes, on the assumption the market has bottomed out and a recovery is around the corner.

No single indicator will drive a tactical decision. “We look at each of them in conjunction with the others — the evidence has to suggest making a shift,” says Stein.

The glory days

The depth of the financial crisis was a great time to deploy tactical asset allocation.

“We started to pick up signals in each of the four indicator categories that investors were overstating the bear case. The macro picture was clearly bad, but we felt like it was getting bad at a slower rate. In other words, the damage was decelerating.”

Valuations were the best in decades for stocks versus bonds, as well as for high-yield debt versus investment-grade debt and government bonds. “Whether you were looking at a P/E ratio or yield spreads of lower-rated credit to government, the valuations were very attractive,” Stein explains.

Finally, sentiment indicators hit rock-bottom levels. With this assessment in place, Stein and his team made a tactical shift that increased their risky asset positions beyond the strategic benchmark, and underweighted lower-risk assets.

They increased their exposure to U.S. equities as well as emerging market stocks, which tend to have the highest beta and go up the most when markets recover. And the team reduced exposure to U.S. government bonds and other triple-A securities while increasing high-yield debt exposure.

The strategy worked. “The last two years — from early 2009 to early 2011 — we earned something on the order of 4% a year just on the tactical asset allocation decisions we made, which comes on top of a lot of alpha we were getting from stock and bond picking,” Stein says.

Those were the “glory days” for tactical asset allocation — if “you were willing to step up to the plate when the night was at its darkest.”

Stein has begun unwinding some of this tactical positioning, since the insights that led to these gains are much more widely recognized by the market as a whole.

Big guns only

Investors looking to go tactical are well advised to leave it to the big guns — firms with the analytical wherewithal to slice, dice and interpret the mountains of information you need to have a handle on.

Buying low and selling high is all well and good in theory, Riopelle says, but is extremely difficult to execute without the proper resources.

You need top-notch economists, area experts on everything from individual sectors to geographic regions, analysts who understand the interplay between geopolitics and the financial system, and an arsenal of highly sophisticated and robust models to process the endless fog of data.

“We have access to [all of this], and even then we don’t get it right 100% of the time,” Riopelle warns.

Stein emphasizes the information-filtering process is key. “It’s not only a matter of getting access to information, but having the ability to separate the signal from the noise. It’s important to have [at your disposal] a lot of people who are thinking about tactical asset allocation all the time,” he says.

The death spiral

One of the risks inherent in tactical asset allocation is getting whipsawed, an industry term for repeatedly being on the wrong side of market trends. For example, you take an overweight position on commodities, and instead of going up, they tank.

In response, you sell off your position, but they go up again. So you buy in again, and before the ink on the transaction slip is dry, they tank yet again. This can get very expensive, very quickly.

The real sting of getting whipsawed on tactical bets stems from the fact that you’re overweighting or underweighting an entire asset class in the portfolio, as opposed to just losing on an individual stock.

“You usually have a lot of stocks in your portfolio, and if one works against you, you have a lot of other things that might be working for you. And you can get comfortable with some things not working out in the portfolio,” Stein says.

Effective tactical asset allocation requires discipline, patience and the ability to live with volatility. If you make a tactical adjustment and the market begins to work against you, it’s not necessarily a reason to undo the shift.

“Being patient can lead to long-term success, and help you avoid getting on that whipsaw cycle. Once you’re on it, it’s very difficult to get off,” Stein explains.

Stein’s advice to individual investors and advisors is to steer clear of tactical asset allocation if they don’t have the patience or the stomach to handle the volatility and uncertainty that comes with it — or the analytical horsepower to discern the opportunities. Plus, it’s easy to lose big money.

And truth be told, tactical asset allocation is not absolutely critical to success as an investor.

“It’s fine to remain a strategic investor. Tactical asset allocation is an important contributor, but it’s not necessarily our primary source of value,” says Stein.

“Our bottom-up stock and bond selection processes are primary sources of value. It’s not critical to the success of our investment program to have the tactical piece working at all times.”