As the trend to sector specialists continues, and the global investment management industry grows, there is a strong argument to include specialist tactical asset allocation (TAA) mandates within fund structures.
This discussion paper from the Commonwealth Group provides an overview of TAA and highlights the value of TAA in providing additional returns. It then reviews the global demand for the product and examines the approach to TAA by one TAA specialist.
The paper also details some of the practical decisions faced by trustees and asset consultants when implementing TAA.
What is Tactical Asset Allocation?
Tactical asset allocation (TAA) is a form of active management
with the aim of adding value through short-term adjustments to
a fund's benchmark asset class exposures.
A fund's strategic asset allocation (ie: benchmark asset class exposures) is determined in order to meet the fund's long-term objectives.
If the expected returns for each asset classes are equal to their long-run expected returns, then the fund's strategic asset allocation will be stable. However, from time to time, expected returns will deviate from the long-run returns, and create opportunities for value to be added by the fund deviating from its long-run strategic asset allocation.
TAA involves tactically increasing a fund's exposure to those markets that the TAA manager's research indicates are relatively attractive and reducing a fund's exposure to overvalued (hence unattractive) markets. The objective is to add value relative to the fund's benchmark within specified risk constraints.
Over an economic cycle, the TAA tilts away from the benchmark exposures should - on average - be zero. The TAA process should not tilt the fund in a sustained manner away from the benchmark asset class exposures.
TAA can refer to domestic TAA, which involves equity/bond/cash decisions within a single country only, or refer to global TAA, which entails creating a diversified portfolio of long and short positions covering multiple equity and bond markets and currencies.
TAA decisions covering equities, bonds, and currencies are usually implemented using a TAA overlay involving futures and forward rate contracts. Derivatives provide a cost-effective tool, allowing timely exposure adjustments to be made across a broad range of asset classes, while avoiding any disruption to asset class managers.
HISTORICAL TAA EXPOSURE
Any fund configured with a balanced mandate will have decided
in favour of TAA either explicitly or implicitly, as most balanced
fund managers use TAA. Trustees provide their managers with strategic
asset allocation benchmarks, and are likely to have also provided
ranges for movements around the benchmark. These managers are
then evaluated on their ability to add value not only through
stock selection, but also by way of asset allocation changes.
Historically, mid-size or large funds employed two or three balanced managers. Recently, trustees have tended to opt for multiple asset class specialist managers. Under this scenario, managers can concentrate resources on their perceived area of expertise, but are limited to adding value through stock selection only. Trustees are then faced with the question as to whether or not to seek added value through TAA, and if so, how.
IS TAA IMPORTANT?
If trustees believe that markets are efficient or if they have
low tolerance for variability in investment returns beyond market
returns, and also have difficulty identifying active management
skills in advance, then their fund should adopt a passive management
style.
However, some trustees believe that it is possible to identify active management skills in advance. In fact, asset consultants spend considerable time researching managers in order to identify those that consistently add value to funds.
TAA is a form of active funds management and is potentially a very important source of alpha, i.e. generating returns to a fund in excess of benchmark. Recent Australian research indicates that while balanced fund managers struggle to generate alpha, specialist TAA service providers were able to do so. Furthermore, TAA may also reduce the volatility of a fund's returns.
GLOBAL DEMAND FOR SPECIALIST TAA
Specialist TAA mandates exist in the United States, Canada, the
United Kingdom, Netherlands, Japan, Hong Kong, Singapore, Australia,
and New Zealand.
TAA's acceptance has been hampered and partly underestimated by labelling problems. In the United States, TAA is often hidden away in the catch-all category of 'alternative investments'. However, US demand for TAA has been growing, and this will accelerate given the correction in the United States equity market.
TAA is starting to gain acceptance in Japan, Hong Kong and Singapore. A small number of TAA mandates have been operating in these markets. However, these mandates are small relative to the potential market size.
In the United Kingdom and Europe, opportunities exist for specialist TAA managers as clients have generally been disappointed with traditional balanced fund managers' performance, particularly their TAA component. However, these markets appear to still be in the early stages of accepting TAA as a specialist service.
In Australia, where specialist TAA services have only been available for the past six years, TAA is starting to be accepted as a central part of a fund's structure. TAA managers are often being employed in the transition process from balanced fund management to sector specialists. More than one TAA manager is often appointed in the case of larger funds.
While the New Zealand demand for TAA overlays has not been high, a number of funds do engage specialist TAA services. Given the acceptance of sector specialists, more funds are considering adopting a TAA overlay. The introduction of large public sector funds is also likely to raise the demand for TAA.
HOW DO SPECIALIST TAA MANAGERS GO ABOUT
MAKING OVERLAY DECISIONS?
By way of example, Tactical Global Management's ("TGM")
process involves two distinct but integrated and consistent stages.
The first stage is economic and financial market outlook; the
second is risk management and implementation.
Economic and Financial Market Analysis
TGM's economic analysis is conducted in a 'global general-equilibrium
framework', which recognises the interdependencies between different
economies, and between financial and other markets in those economies.
The economic analysis covers both the medium-term global general
equilibrium trends and the shorter run domestic business cycle
forecasts.
Jointly determined with the economic forecasts are forecasts for the major equity, bond and currency markets.
TGM's model-based process not only forms the foundation of the central forecasts, but also facilitates extensive scenario analysis.
Risk Management and Implementation
TGM then determines what particular strategy to adopt. It has
developed a risk management process that uses downside-tracking
risk to determine the optimal asset allocation for each specific
fund, given the financial market forecasts and correlations between
asset classes. Each fund's risk tolerance is calibrated such that
the extent of the asset class ranges are optimally used over an
investment cycle. The risk management process then positions each
fund on its efficient frontier at a point determined by its risk
tolerance. Portfolios are reviewed daily.
Derivatives are used to implement the TAA overlay asset allocation decisions.
IMPLEMENTATION QUESTIONS FOR TRUSTEES
AND ASSET CONSULTANTS
The decision to employ a TAA manager is not the only decision
that trustees and consultants need to make concerning TAA. They
also have to decide a number of issues, including:
TAA Trust or overlay?
TAA Trust
A TAA Trust is a balanced fund with very wide ranges. It is usually
designed so that a 10-20% investment by a fund in the TAA Trust
will result in meaningful TAA tilts at the fund level.
A fund can achieve its desired benchmark by investing the other 80-90% with specialist managers, taking into account the benchmark of the TAA Trust.
A TAA Trust is best suited for small funds. By pooling funds in a TAA Trust, the Trust becomes large enough such that the TAA strategy can be implemented in an incremental manner.
TAA Trusts are usually invested in index funds, and the alpha generated is only from TAA. This approach also means that there are no issues to resolve as to whether or not the TAA manager should take into account the positions of the underlying managers.
TAA Overlay
A TAA overlay is tailored to each client, taking into account
the exact specifications of the fund's TAA range constraints and
any joint constraints.
A TAA overlay can do more than a trust. For example, it can be tailored to the exact requirements of the client. A TAA overlay can incorporate a rebalancing service; it can also provide assistance with any changes to a fund's structure.
Should TAA Include Rebalancing?
Over time, as asset values change, a fund's asset holdings will
move away from its strategic asset allocation benchmark. A TAA
manager can "rebalance" the fund back to its benchmark
on a regular basis without requiring the trustees to switch funds
from one manager to another.
Rebalancing stops 'leakage' (the potential for returns to vary from expected returns) if asset exposures move significantly away from the benchmark.
Correspondence
All correspondence in relation to this discussion paper may be
directed to:
Rosemary Hambling
Colonial First State Investments Managers (NZ) Ltd
P O Box 5108. 117 Customhouse Quay,
Wellington, New Zealand
(04) 470-4500
rhambling@colonialfirststate.co.nz
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