Aviva's Adrian Jarvis looks at the benefits of tactical asset allocation funds
Since the 1950s, investors have understood and accepted the need for strategic (long-term) asset allocation (SAA) and have created diversified portfolios to maximise risk-adjusted returns over the long term. SAA involves the creation of an optimal ‘base’ or ‘benchmark’ portfolio followed by a series of continuous, yet relatively infrequent and (in normal market environments, minor) refinements to that portfolio. The aim being, via the periodic adjustments, to maintain a portfolio that is best suited to a client’s long-term risk-reward objectives.
What is TAA?
Less well understood, however, is the utilisation of tactical asset allocation (TAA) as a means of exploiting short and medium-term market inefficiencies. So what is TAA and how does it work? TAA has its origins in the 1970s when portfolio managers sought to tweak their domestic asset allocation mix to capture short-term opportunities and therefore improve risk-adjusted returns.
By the 1990s, the steady liberalisation of international capital markets seen over the previous decade, together with the rapid growth of derivatives markets, was encouraging managers to adopt a global perspective. Having previously concentrated on domestic asset markets, increasing numbers of investors began to employ TAA in an international context in an effort to exploit inefficiencies on a global scale, heralding the introduction of global tactical asset allocation (GTAA).
By employing technical or economic analysis, or a combination of the two, managers of TAA funds seek out asset classes (equities, bonds, currencies) and regions that appear mispriced relative to one another or to cash, and seek to provide attractive risk-adjusted returns. In a TAA fund positions are usually only held for a relatively short period of time – typically less than a year – hence the word ‘tactical’.
Using derivatives
If the TAA manager’s analysis suggests equities should continue to rise in the short term due to a sudden improvement in the economic environment, they could choose to buy stock-index futures in an attempt to profit from the expected advance in share prices. If the equity market does indeed climb, the position will be closed out for a profit. Taking positions using derivatives is an important feature for a TAA manager as it provides the ability to ‘go short’, is a cost effective way of trading and allows trades to be taken quickly given the highly liquid nature of the derivatives market.
From overlay to opportunity
Until 2002, however, TAA was not widely accessible to investors. Previously it had only been available as an ‘overlay’, as a means of permitting limited deviations from the SAA benchmark within an existing fund. Changes in EU legislation that came into effect in 2002 made the strategy available via stand-alone funds. The implementation of the Ucits III directive widened the range of financial assets and instruments, including derivatives, available to managers of stand-alone funds. TAA funds are now able to invest in a wider opportunity set that includes markets not in the strategic benchmarks and the changes also give TAA funds the ability to adopt a net short position if the manager believes the prospects for a specific market are poor in the short term.
In addition to attractive risk-adjusted performance, returns generated by TAA funds tend to have little correlation with more traditional asset classes such as equities or bonds.
This is because TAA funds capture a wider opportunity set than that available through investment in single equity or bond markets. Furthermore, both long and short positions can be implemented using derivatives so the strategy will sometimes generate profits in rising and sometimes in falling markets. The introduction of a new uncorrelated source of returns leads to an investor’s efficient frontier expanding upwards, giving investors a greater potential return with the addition of little or no risk.
TAA funds are designed to consistently deliver positive returns. They seek to do so by exploiting short-term opportunities in ‘conventional’ asset classes such as equities, bonds, currencies, real estate and cash. They provide investors with a distinct opportunity set which tends to have little or no correlation with more traditional asset classes and can potentially improve the risk/return characteristics of an investor’s portfolio.
Adrian Jarvis is head of investment strategy at Aviva Investors
