Strategic versus Tactical Asset Allocation

The medical industry is known for its complex and confusing terminology. People become baffled over terms such as “dilate” – which many think means to live longer or “coma” – which some think is a punctuation mark.

The financial industry is also no slouch when it comes to jargon. Consider “stock-split”, which could apply to your ex-wife/husband and lawyer splitting your assets between themselves, or “profit” which, let me tell you, is not someone who talks to God.

Asset allocation terms
We’d like to clear up two important financial terms that can be rather confusing. Both terms are key to how you manage your portfolio. They are: “strategic” and “tactical” asset allocation. Both types refer to a particular mix of stocks, bonds, cash, and potentially other asset classes.

A landmark study by Brinson, Hood and Beebower in 1986, and a follow-up study completed in 1991, attributed the variability of returns in a sample of over 90 large U.S. pension plans to three different decisions: asset allocation, market timing, and security selection. They found that over 90 per cent of return variability was explained by a fund’s asset allocation, that is, the way asset classes were combined.

Clearly, over time, asset allocation decisions say more about how a typical portfolio performs than any other investment decision.

Strategic Asset Allocation
Strategic asset allocation is an investment theory based on the principles of a Nobel prize winning dissertation. At the inception of the portfolio, a base policy mix is established, founded on expected returns and risk. Then the asset class mixes are rebalanced to target weights according to the original mix, usually at regular intervals such as monthly or quarterly, to maintain a long-term goal for asset allocation.

In other words, there is no attempt on the part of the managers to purposely deviate from the original determined weights. The emphasis is on preserving the fixed weights because they ultimately relate to a larger performance objective based on historical data.

Tactical Asset Allocation
The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework to seek to create an additional source of return. An attempt is made to take advantage of short and intermediate term market inefficiencies as a means of managing investors’ exposure to market risk.

Managers normally do this by evaluating the relative attractiveness of equity and fixed income markets through financial valuation, growth and sentiment measures. They will then use a systematic process to evaluate the different asset classes.

The investment philosophy is usually based on the belief that investor psychology and market forces can lead to periods of misevaluation. A tactical allocation process attempts to capture these misevaluations. It is not a fixed asset weight mix and the allocation and the risk level of a portfolio may change quite dramatically.

Which is better?
Today’s investors clearly face significant challenges in meeting investment objectives, particularly in an environment of relatively modest returns. Identifying and efficiently executing an appropriate asset allocation strategy to meet those investment objectives is important.

Neither strategic nor tactical portfolios will shoot the lights out, as they are structured to obtain a specific return for a particular risk over a market cycle (generally defined as eight to ten years). One style will not necessarily produce a better return or offer less volatility than the other over a market cycle. But each has an approach that is easy to understand and can be adhered to using discipline. Strategic may be appropriate for investors who would like to see a mix that does not change with the markets, and strive to rebalance by buying when prices are low and selling when prices rise. They know what the allocation to assets was at the beginning and want to maintain that mix through all market conditions.

Tactical would be more suitable for investors who want to see the sails of their ships adjusted as the winds change direction. They want to see their portfolios take advantage of asset class opportunities. Tactical asset allocation practitioners tend to emphasize shorter-term adjustments, reducing exposure when recent market performance has been good, and increasing exposure in a slipping market.

In our opinion, neither one is better than the other. They represent two different approaches to a similar result.

Best practices
Investors often ask us to identify the best practices surrounding the design and implementation of portfolios. Generally speaking, we suggest that investors must realize that asset allocation is critical when seeking an investment strategy. They should spend a great deal of time and effort on making sure their asset allocation strategy best reflects their temperament, time frame and goals.

We recommend that you, as an investor, continue to examine the approach you are taking to the allimportant allocation decision. Ask yourself “what kind of portfolio do I have? – strategic or tactical. Who makes the asset allocation decisions for my portfolio? What is their skill set? Are they independent and can they make unbiased decisions?”

Once you have decided on the best approach, the next step is to evaluate the investment manager selection process. After asset allocation in importance is the objectivity of the investment manager selection process. You should know if the team making the allocation is related to the parties being allocated to. In other words, the asset allocation manager should be separate from the managers who are selected to administer each mandate within your allocation model.

Without this protection, some allocations could go to investment managers who need assets to ensure that they produce a profit for the entire investment firm.

True independence in the portfolio structure is vital. You should end up with a set strategy for asset allocation and a specific investment manager selection process, all within one portfolio.

It is fundamental to decide upon an investing strategy, and stick to it. It can be compared to setting a course when starting on a long journey and following it faithfully. You adjust your route only when conditions change.

If you would like to review your current asset allocation strategy, as well as your investment manager selection process, please call our office for an appointment.

Investment Planning Counsel is the CARP-recommended financial planning and wealth management resource. Click here for more information.