Tactical asset allocation (TAA) refers to an active management portfolio strategy that shifts asset allocations in a portfolio to take advantage of market trends or economic conditions. In other words, tactical asset allocation refers to an investment style in which asset classes such as stocks, bonds, cash, etc. are adjusted in the portfolio to account for macroeconomic events.
The ultimate strategy of tactical asset allocation is to maximize portfolio returns while keeping market risk to a minimum.
Understanding Tactical Asset Allocation
The underlying premise behind tactical asset allocation is to first focus on asset allocation and securities selection second. Those who invest using a tactical asset allocation look at the “bigger picture” and believe that the allocation of assets exerts a greater impact on portfolio returns than individually selecting securities.
For example, consider the data below regarding the S&P 500 return (“stock return”) and Barclays U.S. Aggregate Bond Index (“bond return”) return. Note that cash does not generate a return:
As one can see, stock returns outpaced bond returns from 1997 to 1999. From 2000 to 2001, bond returns outpaced stock returns.
A tactical asset allocation strategy might show the following asset class allocation over the years:
Compared to an investor that might have solely invested in stocks from 1997 to 2001, tactical asset allocation would have mitigated the poor performance of stocks in 2000 and 2001 by shifting the asset allocation to bonds.
In essence, the goal of tactical asset allocation is to adjust the asset class in a portfolio to asset classes that are expected to perform better relative to other asset classes.
Example of Tactical Asset Allocation
In his investment policy statement, X indicated that he wants an asset allocation consisting of 45% stocks / 45% bonds / 10% cash. Historically, stocks have performed extremely well.
The portfolio manager of X recently noted that the yield curve has inverted, a leading indicator of a recession. The portfolio manager tells John that the portfolio’s asset class should be shifted to 20% stocks / 70% bonds / 10% cash due to fears of a recession and potentially poor stock returns. In doing so, the portfolio manager is employing a tactical asset allocation strategy.
Tactical Asset Allocation within an Asset Class
Tactical asset allocation can also be used within an asset class. For example, consider the asset class allocation of 20% stocks / 70% bonds / 10% cash. We can use tactical asset allocation within an asset class as follows:
Within 20% stock allocation:
How Tactical Asset Allocation Works
As an investor setting up a tactical asset allocation, we may arrive at a portfolio that matches our goals and risk tolerances. A moderate mix of assets for a starting portfolio might contain:
- 65% of stocks
- 30% of bonds
- 5% cash
Depending on current or expected market fluctuations or economic conditions and our investment goals, allocating a specific asset (or more than one asset) can adjust over time. The assets may be structured like this:
- Neutral-weighted — performs at par with the market
- Over weighted — outperforms the market
- Under weighted — underperforms the market
We have a current asset allocation of 65/35/5 based on the previous example. That allocation is our target allocation and is “neutral-weighted.” Now let’s assume that the market conditions and economic situation changes and stocks rise in value, and the bull market appears to be maturing.
As investors, we think stocks are expensive, and a bear market is coming shortly. We may then decide to take steps to reduce our allocation to stocks and move away from the market risks and towards a more conservative allocation mix — for example, 50% stocks, 40% bonds, and 10% cash.
We have under-weighted stocks and over-weighted bonds and cash in the above scenario, all based on the target portfolio we created earlier. We may choose to continue reducing our exposure to stocks and their risk as the bear market progresses, and a recession appears.
In fact, we may move to almost all bonds, and a reduced stock allocation as the bear market becomes more evident. As the bear market progresses, we might slowly add to our stock positions as a tactical asset allocator as the opportunities present themselves. At the same time, doing all of this in anticipation of the next bull market.
Reasons for Tactical Asset Allocation
1. Increasing Returns
Using tactical asset allocation to shift asset allocations to stronger performers increases the portfolio return. Doing so allows the portfolio to capture the upside in an asset class while moving away from poorly performing asset classes.
2. Adapting to Market Conditions
Tactical asset allocation is flexible and responds to macroeconomic events. As seen with the stock market in 2000 and 2008, stocks significantly underperformed several other asset classes. A tactical asset allocation strategy shifts the asset allocation accordingly to account for macroeconomic conditions.
3. Providing Diversification
Investing solely in one asset class increases the risk of the portfolio. By diversifying through tactical asset allocation, greater returns can potentially be realized with lower risks.
