Wednesday, July 11, 2007

A Primer on Tactical Asset Allocation

The following Vanguard Institutional Paper examines the risks and rewards of Tactical Asset Allocation. Some definitions are in order (courtesy of investopedia):

Strategic Asset Allocation:
What does it Mean? A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation.

Investopedia Says... At the inception of the portfolio, a "base policy mix" is established based on expected returns. Because the value of assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy

Tactical Asset Allocation:
What does it Mean? An active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors.

Investopedia Says... This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace. It is as a moderately active strategy since managers return to the portfolio's original strategic asset mix when desired short-term profits are achieved.

A Primer on Tactical Asset Allocation

Yesim Tokat, Ph.D.
Kimberly A. Stockton

Many pension funds, endowment funds, and other institutional investors are concerned that equities—typically their largest asset allocation—will have lower average returns over the next decade. In this environment, many investors have questioned the wisdom of thinking about asset allocation solely in strategic terms and have shown renewed interest in tactical approaches. Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio’s strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances in equilibrium values among different asset or subasset classes. Over time, strategic long-term target allocations are the most important determinant of total return for a broadly diversified portfolio. TAA can add value at the margin, if designed with the appropriate rigor to overcome significant risk factors and obstacles unique to the strategy. Our results show that while some TAA strategies have added value, on average TAA strategies have not produced statistically significant excess returns over all time periods. This raises several important questions for institutional investors: What tools and processes do they need to have in place to make optimal decisions regarding TAA strategies? What are the right questions to ask a prospective manager? What are the critical components of a good model if they choose to run a TAA strategy in-house? This paper provides answers to these questions.

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