Wednesday, July 19, 2017

Tactical Asset Allocation

If you have read enough portfolio publications and books, you may have came across this term called “tactical asset allocation”. According to Investopedia, tactical asset allocation is “an active management portfolio strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors”.1 In other words, your portfolio’s asset class allocation will change according to the prevailing environmental factors and economic conditions.

Taking the balanced Bedokian Portfolio for example (35% equities, 35% REITs, 20% bonds, 5% commodities and 5% cash), if the market is pointing to a boom period where equities and REITs are likely to gain, and in order to capture their rise, you would adjust your portfolio to 40% equities and 40% REITs, while reducing the bond component from 20% to 10%. Then with recession looming, you would increase your bond holdings to 30%, and reduce equities and REITs to 30% each, since bonds perform better in such times.

Besides asset classes, tactical asset allocation can also be done on a sector/industry level. During recession times, defensive sectors/industries such as utilities and consumer staples fare better than others, so more allocation is given to them. Sometimes asset class and sector/industry tactical asset allocation can be done together. All these are done in an attempt to maximize returns given the situation. Since the tactical asset allocation is done based on the economic cycle, this investment style is also known as economic cycle investing.

The Economic Cycle

The economic cycle, or sometimes referred to as the business cycle, is “the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession)”.2 There are various sub-stages within this broad view of expansion and recession, and the typically accepted stages are expansion, peak, recession and trough (see Fig. 1).

Fig. 1 – The economic cycle

About Strategic Asset Allocation

Let me share a bit about strategic asset allocation, where it is “a portfolio strategy that involves setting target allocations for various asset classes, and periodically rebalancing the portfolio back to the original allocations when they deviate significantly from the initial settings due to differing returns from various assets”.3  This means come rain or shine, the portfolio asset class allocation remains the same. The Bedokian Portfolio is a form of strategic asset allocation, and rebalancing back to your preferred asset class allocation periodically is part and parcel of the overall strategy.

The Bedokian’s Take

Portfolios using tactical asset allocation have their merits on the theoretical assumption of having more returns in a given economic cycle condition than strategic asset allocation, since the asset class/sector/industry that perform well at that moment is given more weightage to capture the returns as compared to strategic asset allocation ones. However, from the perspective of The Bedokian Portfolio, whether you are an active or passive investor, it is better to stick to its original form.

It is hard for any investor to predict the direction and behaviour of the markets and economy, let alone know at which point the economic cycle is at, even with ready information on hand. Fig. 1 is a perfect example on how the economic cycle looks like, but in the real world this may not seem so. The expansion could be longer or shorter than the recession phase, and sometimes what is deemed to be down (or up) could quickly reverse to go up (or down). In this case, it is better to be more reactive and less proactive.

Even if you are able to guess the movements of the markets, the constant rebalancing of your asset classes and sectors/industries would incur more transaction costs than even a normal active Bedokian Portfolio investor, and this in turn means lesser returns.

However, I am not totally against tactical asset allocation, just try not to use it on your Bedokian Portfolio. Remember, the main aim of it is “passive income through dividend and index investing”. If your capital allows, you could have another portfolio that uses the tactical way, which is good for a topic of discussion for another day.

1 - Investopedia. Tactical Asset Allocation - TAA. (accessed 17 July 2017)

2 – Investopedia. Economic Cycle. (accessed 18 July 2017)

3 – Investopedia. Strategic Asset Allocation. (accessed 17 July 2017)

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