Tactical Asset Allocation

Sources of alpha
Security selection (traditional active managers)
Exploiting time-varying risk premia (Tactical Asset
Allocation)
Tactical Asset Allocation
Strategic Asset Allocation (SAA/LTP’s Policy Portfolio) is
developed assuming steady, constant risk premia (capital
markets assumptions) over a long period (7-10 years)
Asset prices are assumed to be in an equilibrium
However inefficiencies arise in the markets for various
reasons (e.g., asset bubbles) leading to temporary imbalances
in equilibrium values
The assumption of constant, steady risk premia does not hold
Tactical Asset Allocation (TAA) seeks to exploit these
market inefficiencies to generate excess return (alpha)
It is a dynamic strategy
TAA - Process
Need to have opportunistic/short-term views
(qualitative, quantitative or a combination of the two)
The ranges around asset classes in the LTP naturally
lend themselves to implementation of TAA
They allow overweighting /underweighting asset
classes based on our views
Tactical views could be incorporated with active
rebalancing
Views based on
valuation, sentiment, fundamental and behavioral
dynamics
Style factors: value, momentum, carry, trend etc.
TAA – Process
Tactical tilts within an asset class based on factor
scores tend to be consistent
Long EM Debt, Short US Debt/Developed Debt
Long HY Debt, Short IG Debt
Long EM Equity, Short Developed Equity
Between asset classes, care should be taken to ensure
that measures are consistent
Implementation should ensure that positions express
only the intended view with no extraneous exposures
TAA – Process
When applied between asset classes, TAA could
increase portfolio concentration relative to Policy
Portfolio (a move of 5% from Fixed Income to Equity
would increase Equity allocation to 70%).
When asset class correlations are high, diversification
does not offer much benefit. TAA could add value in
such instances
However when asset class correlations are low and
diversification opportunities exist, TAA would have a
higher hurdle rate
TAA – Performance & Sizing
Sizing could be determined from target tracking error
 E.g., a target tracking error of 100-150 bps could be set
and position sizes be determined accordingly.
TAA performance could be measured by Information
Ratio (IR) relative to Policy Portfolio
Positive IR indicates value add from TAA
An IR of 0.4 with tracking error of 100-150 bps could
add 40 – 60 bps of return to the overall portfolio
TAA – quantitative approach
Black Litterman model could be used to estimate optimal tilts from the
Policy Portfolio
Estimate equilibrium returns from Policy Portfolio
Express asset class views either in
 absolute terms (US Equity return = 6%) or
 relative terms (EM Equity outperforms EAFE Equity by 2%)
Specify confidence in our views (certainty)
Bayesian updates of expected returns and covariance matrix could be
calculated from the above inputs
Mean Variance portfolio optimization could be solved with updated
expected return and covariance matrix estimates
Constraints on tracking error will result in a tactical portfolio with
required sizing
With entropy pooling, more flexible views could be incorporated
TAA – third party managers
Many managers offer TAA products that have low
correlations to equity and bond markets.
Both fundamental and quantitative products are
offered
Disadvantages:
Lack of control
May not be transparent so poses challenges in
developing an integrated framework for SAA and TAA