There are many different strategies that active traders and investors employ to generate alpha in their portfolios, ranging from value investing to technical analysis. Tactical asset allocation is the most common strategy used by investors looking to capitalize on cyclical trends in the market.
In this article, we will look at tactical asset allocation, differences with strategic asset allocation, and some common strategies for investors to consider.
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What Is Tactical Asset Allocation?
Asset allocation refers to the mix of assets held in a portfolio. While most people may think of stock-to-bond ratios in retirement portfolios, asset allocation encompasses all kinds of assets and investment strategies. The goal is to identify the right mix of assets to capitalize on a cyclical trend or meet an investor’s risk and return requirements.
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Strategic asset allocation is focused on the latter — identifying the correct mix of assets to meet an investor’s risk and return requirements. Vanguard research has shown that these long-term asset allocations account for ~90 percent of a portfolio’s returns and volatility over the long run, which makes it an important part of a passive investment strategy.
Tactical asset allocation is a short-term strategy designed to capitalize on cyclical trends in the market. Rather than selecting specific investments, active investors use these strategies to profit from trends affecting entire asset classes. It’s an important active investment strategy employed by individual investors, professional traders, and hedge funds.
Tactical Asset Allocation Strategies
There are many different tactical asset allocation strategies depending on the investor’s goals. In addition, there are many different ways that investors can participate in these strategies. Some investors may be comfortable maintaining their own portfolio of individual securities, while others may prefer to use actively managed funds that employ these strategies.
Let’s take a look at the three most common strategies:
- Systematic tactical asset allocation strategies use a quantitative investment model to exploit inefficiencies or temporary imbalances in equilibrium pricing across different asset classes. For example, the historical spread between two types of bonds may be unusually high, which could lead an investor to set up an arbitrage trade.
- Sector rotation tactical asset allocation strategies look at the tendencies of certain sectors to outperform during certain parts of the economic cycle. For example, the basic materials sector tends to outperform during the early stage of economic recovery due to the increase in demand for raw materials used for infrastructure and other projects.
- Global macro tactical asset allocation strategies seek to shift asset allocations based on global market trends. For example, strength in basic materials could lead investors to shift assets from United States tech stocks into emerging market mining companies to maximize returns. These strategies may require a lot of global market expertise.
It’s important to consider your performance requirements, risk tolerance, and time horizon before investing in tactical asset allocation strategies. For example, you might analyze risk and return by looking at the Sharpe Ratio and only invest in opportunities that are likely to play out within your desired time horizon (e.g., avoiding multi-year sector rotation).
Investing in Tactical Asset Allocation
There are hundreds of different mutual funds and exchange-traded funds (ETFs) that employ tactical asset allocation. In addition to using different strategies, these funds have different expense ratios, liquidity levels, and other characteristics that investors should consider before committing any capital.
The funds can be broken down into four categories:
- Tactical Adjustment: Funds that shift capital between asset classes to maximize risk-adjusted returns.
- Cash Equalization: Funds that maintain a fully invested portfolio with minimal cash balances.
- Transition/Rebalancing: Funds that permit cash to remain invested while switching between asset managers.
- Hedging: Funds that enable investors to reduce risk to certain markets without selling underlying holdings.
Active investors may also decide to build their own tactical asset allocation strategies using the many asset class-specific ETFs on the market. For example, you can easily shift capital from the U.S. to emerging markets by purchasing emerging market ETFs, such as the iShares MSCI Emerging Markets ETF (EEM), without having to worry about managing individual stocks.
The Bottom Line
Tactical asset allocation is an important active investing strategy used by many individual, professional, and institutional investors. In addition to the many tactical funds available, investors can also build their own strategies by using a combination of different asset classes or simply choosing a specific ETF designed to meet such an objective. However, it’s important to keep the risks in mind when using these strategies.
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