When to employ tactical asset allocation
Most investors would agree that this is decidedly not a normal recovery from a normal business cycle recession
Most investors would agree that this is decidedly not a normal recovery from a normal business cycle recession. Rather, in our view, the current recovery in growth and in financial markets of late has been built on the back of extraordinary stimulus measures in the wake of an unprecedented global financial crisis.
We believe the crisis stemmed from, and revealed, structural flaws in the global monetary and financial systems, and that these flaws — massive imbalances in savings and consumption, sovereign-debt overhangs and moral hazard in banking — remain.
Transitioning to a more normal recovery environment, with normal policy settings, is now the great challenge for policymakers. Allocating assets sensibly relative to the uncertainties of this transition phase is the great challenge for investors.
The past few years have left many investors shellshocked. Risk tolerance has become even more difficult for most people to define and the tendency to follow the herd more difficult to resist.
CONSERVATIVE APPROACH
In this environment, we believe a sensible approach is to set one’s strategic-asset-allocation mix at a more conservative level than might otherwise seem appropriate and, tactically, to increase risk only when risky assets offer compelling value. In other words, keep dry powder available for when it makes sense to use it.
Most investors, however, do not seem well-equipped to execute a tactical strategy, and this is where tactical-asset-allocation products can help. What is needed is such a product with an absolute-return objective, one that seeks to increase market exposures (beta) when valuations are attractive and reduces these exposures as valuations get stretched, ideally allocating into alpha strategies with little or no beta. This is distinct from tactical strategies that simply allocate to the beta exposure that is most attractive at any given time.
When selecting a tactical-allocation/absolute-return product, investors should look for well-defined and rigorous processes for asset valuation, risk management and portfolio construction, and also for a diverse set of consistent alpha engines.
The process starts with valuation, and valuation must be placed in the proper historical context. For equities, earnings and profit margins should be normalized over a long period, such as 10 years, and should include all the warts of reported, as opposed to operating, earnings. For high-grade bonds, nominal and real yields, as well as forward rates, should be measured relative to nominal and real gross domestic product growth rates and expected future growth rates. Lower-quality bonds should be measured in the context of historical default and recovery rates, and extreme spread-volatility ranges.
The risk management process should be both quantitative and qualitative. Historical data can be broken down into risk parameters to identify how these characteristics perform and correlate to one another in different types of past market environments.
This allows for re-weighting of correlations and for stress-testing portfolios under alternative scenarios of better or worse market conditions.
Finally, access to alpha-generating building blocks is essential. If a manager has a diverse set of consistent alpha engines, he or she can rely more readily on these to seek returns, while also dampening risk. Thus the potential availability of alpha raises the hurdle rate for taking beta risk.
ALPHA OR BETA?
Alpha engines are distinct strategies to which the manager allocates funds. They may be market-neutral (long/short) products or hedged versions of long-only products, but in each case, the process should be well-defined and visible to the manager.
He or she should understand, in each case, the source of the alpha and should consider past, and likely future, correlations among the available alphas.
Within this framework, the tactical-asset-allocation manager seeks to add beta exposure when valuations are attractive, and throttle back this risk and focus on alpha-driven returns when valuations appear extended.
If the normalization phase we anticipate turns out to be a bumpy ride and produces shorter market cycles and expanded volatility ranges, this strategy could be appropriate. Otherwise, the focus on alpha returns may provide welcome diversification and dampening of risk within a total-portfolio context.
Thomas Shively is a portfolio strategist with Eaton Vance Investment Managers.
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