Tactical Allocation: Winning Strategy or a Fool’s Game?

October 4, 2019  | by Deborah Spalding, Kristofer Kwait

Asset Allocation | Investment Strategy | Risk Management

Institutional investors overseeing long-term pools of capital typically define their strategic asset allocation with specific targets and bands or ranges around those targets, which allow for tactical positioning. These bands are also used to trigger rebalancing trades to ensure a disciplined approach to maintaining the stated portfolio allocations. At Commonfund, we define tactical asset allocation as intentional market timing – taking over- and under-weight positions around the policy portfolio targets. For example, if we were to say we are “overweight equities relative to our policy portfolio”, that is a tactical allocation decision. Much of the asset management industry has been built on the belief that some investors can consistently predict what the market will do and where it is going. It’s not surprising – in an uncertain world selling the idea that knowing the future is a skill that can be harnessed to deliver superior results is extremely appealing. But, are professional investors able to consistently predict where the market is going and profit from that knowledge? In this blog we will share what we see in the data and how our research informs us as investors.

What Do We See in the Data?

To better understand the merits (or not) of tactical allocation we looked at a Bloomberg asset manager universe of roughly 400 tactical asset allocators. Each manager had at least a two-year track record over a twenty-year look-back period. The blue dots in the figure below each represent one of these managers – plotted by degree of market timing (X-Axis) and return versus their stated benchmark or Alpha (Y-Axis). This analysis attempts to answer two questions.

img-CH-01-TacticalAllocation-WinningStrategy

Question 1: Do the managers in this universe have skill at market timing?

We used regression analysis to identify and isolate the primary risks that these managers take in their strategies – equity and interest rate risk – to see if they generate excess returns after we control for these factors. The 24% of managers represented by the blue dots that fall above the black zero line are delivering alpha through their tactical allocations. However, a full three quarters or 76% of the managers on this chart are delivering negative alpha through market timing and detracting from returns for their investors.

Question 2: Is there a relationship between performance and the degree of market timing a manager engages in?

We used a second regression analysis to account for each manager’s variability in their market risk or beta exposure over time. The managers (blue dots) to the left are timing the market less often, and managers to the right are timing the market more often. The orange best-fit line shows the relationship or correlation between skill and the degree of market timing. We can see that the line is sloping down, meaning the more a manager tries to market time the worse their performance.

These two simple analyses indicate that investors should be wary of managers who claim to able to add value through tactical allocation tilts. The numbers indicate that is exceedingly difficult – and keep in mind that these are the survivors in the universe – it doesn’t include the funds that closed during the twenty-year period!

Measuring and Sizing Tactical Risk

Among the many reasons that winning with tactical bets is so difficult is that it requires getting three things right:

1

Which strategy/region/asset/trade to over- or under-weight,

2

When to get in, and

3

When to get out.

Given the difficulties, it behooves those who still want to take this approach to understand exactly how much risk they are budgeting for this activity – and sizing it appropriately.

As a simple illustration, the chart below starts with a strategic policy portfolio allocation of 70 percent equities and 30 percent fixed income and then looks at how 10 percent and 2.5 percent over-weights impact tracking error and potential underperformance versus the policy portfolio (risk) over time. Over this period the cost of being wrong with a 10 percent equity overweight swings between a low of 80 basis points and a high of 260 basis points. These are significant numbers in the context of the total portfolio. At the other end of the spectrum, the blue line shows the risk of a significantly smaller 2.5 percent overweight to equities. At first blush this may seem like a small bet to take, but it has the potential to drive 20-60 basis points of over- or underperformance. When sizing our tactical bets, we think about how that risk contribution compares to the highest conviction manager in a portfolio – aiming to keep it in-line or less than what we expect from any single manager.

img-CH-02-TacticalAllocation-WinningStrategy

Winning the Fool’s Game

Given our research findings discussed above, one might assume that Commonfund avoids making tactical bets in the portfolios that we run. However, despite the evidence, we do believe that tactical allocation can add value, but the devil is in the execution details. Our approach includes three critical guiding principles. First, we believe that tactical tilts should align with the long-term horizon of our institutional clients so we evaluate any opportunities with the expectation that we should take positions for months or years, not days or weeks. Our process focuses on four catalysts that we believe are the most important when evaluating market opportunities or threats:

a

Growth

b

Inflation

c

Monetary policy

d

Interest rates

Note – these are all longer-term fundamental indicators – not short-term technicals like price action or sentiment. We track several data points and measures against each of these catalysts.

Second, we believe that a consistent process is critical, so we look at the same measures every month without deviation. We do this to avoid the temptation to adjust the data to fit with a pre-determined view or bias. Below is an example of the summary dashboard that we use.

img-CH-03-TacticalAllocation-WinningStrategy

Third, as discussed above, we are very careful about sizing a tactical position when we institute one. The reason for this gets back to our skepticism about adding value through this lever. At Commonfund, we believe that our edge is in designing a strategic allocation, manager selection and access, and delivering the liquidity premium to investors. Thus, we are careful to appropriately size any tactical allocation risk so that it does not overwhelm the potential return benefits of those components. And, we only take a tactical position when our conviction is high and supported by the data and our process.

Find out more about our investment philosophy and how we can help your institution.

Authors

X
Kristofer Kwait is co-CIO of Commonfund Asset Management Company (“COMANCO”), Investments, responsible for leading the marketable equities, fixed income, hedge funds and real assets investment teams as well as analytics. Prior to his current role, Kris was head of the Hedge Fund Strategies Group. Previously, he served as head of hedge fund research with responsibility for overseeing the design and implementation of proprietary models for manager selection, portfolio construction, and risk management. Before joining Commonfund, Kris was a proprietary trader at both Andover L.L.C. and A.B. Watley, where he managed relative value equity strategies. Prior to his experiences as a trader, he was a stockbroker at Smith Barney. Kris attended pre-college at Juilliard School of Music, has a B.S. from Purdue University and an M.B.A. from the Yale School of Management.
Kristofer Kwait
co-Chief Investment Officer
X
Deborah Spalding is Co-Chief Investment Officer of Commonfund Asset Management Company (“COMANCO”) and Chairs the Asset Allocation Committee. She is responsible for the design, tailoring, and implementation of custom investment solutions for investment advisory clients. She also leads Commonfund’s sustainable investment efforts. Prior to joining Commonfund, she was the Chief Investment Officer for the State of Connecticut’s $30 billion Retirement Plans and Trust Funds. Previously, she was a Managing Partner at Working Lands Investment Partners, LLC, an independent investment management firm that invests in rapidly growing environmental markets. Prior to that, she held a number of executive level positions including Executive Vice President and Head of International Investments for Schroders Investment Management N.A. and Managing Director and Head of International Institutional Investments at Scudder Kemper Investments. She began her career as an equity analyst at SKB & Associates in San Francisco. Deborah received a B.A. in International Relations and Asian Studies from Tufts University and holds graduate degrees from Harvard University, University of California Berkeley and Yale University. She is a past Board Chair and a member of the investment committee of the National Wildlife Federation, and an advisory board member of the Center for Business and the environment at Yale and is a Lecturer in Forest and Ecosystem Finance at Yale.
Deborah Spalding
co-Chief Investment Officer, CFA
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.