Asset allocation: Why the strategic versus tactical debate matters
Seen as the building blocks of a portfolio, strategic and tactical asset allocation processes should work in tandem to deliver on-target and risk-adjusted returns. Here, the two processes are analysed to see how they complement each other to deliver long-term results. Barry Widdows, Head of Multi-Asset Portfolio Management & Phil Butler, Multi-Asset Portfolio Manager at Prudential Portfolio Management Group (PPMG) share their analysis.
Need for sustainable Alpha
Investment returns from even the most well-diversified multi-asset portfolios are likely to be subdued for the foreseeable future as an environment of super-normal monetary policy and low yields continues.
Alongside stretched valuations in a number of asset classes, the need for proper asset allocation to generate sustainable alpha has never been greater.
For many investors the key to delivering better multi-asset returns comes down to using complementary strategic and tactical asset allocation processes.
While the difference between strategic and tactical allocation is fairly clear cut, more often than not the same fund team is involved in researching and implementing both. Yet the two forms of allocation require significantly different approaches and ways of thinking.
“Investment markets constantly adjust to new information and asset prices can often be more volatile than the underlying fundamental. This can lead to them overshooting based on changing investor perceptions on a short-term basis,” explains Barry Widdows, Head of Multi-Asset Portfolio Management at Prudential Portfolio Management Group (PPMG). “This volatility can create mispricing of asset classes and it is only through a tactical asset allocation process that managers can take advantage of those trends and opportunities. We believe that the best way to generate strong absolute returns and alpha is to start with a really strong strategic asset allocation as a foundation and combine that with a modern dynamic tactical asset allocation process.
Widdows believes an individual focus on both of these areas is key to delivering returns in multi-asset today, as both processes provide quite different market insights that are able to inform portfolio decisions in unique ways. The group’s long-term investment strategy team for example analyse a range of strategic factors and aim to position a portfolio to benefit from the medium to long-term capital market views. This process allows the team to take into account the secular views and associated regime changes likely to happen, as well as broad high level perspectives on the current cycle into the investment philosophy.
Meanwhile, a separate portfolio management team focuses on tactical asset allocation which is a secondary research process that complements strategic asset allocation as a whole. On a tactical basis, the portfolio management team aims to analyse shorter-term behavioural and market timing insights on anything from a one month to 18 month outlook.
Phil Butler, Multi-Asset Portfolio Manager at PPMG, explains: “The way we frame our theory is strategic asset allocation is looking at an outlook of three-to-five years plus. And whilst a rational investor should price an asset to return its objective over long time frames of this sort, in the short term assets do tend to deviate away from their true value. Our aim is to tactically take advantage of those opportunities that are presented before us.
The evolution of tactical asset allocation in the industry over the past 15 to 20 years has seen a growth in the asset class coverage, according to PPMG. At the time of the tech bubble in 2000 for example, tactical asset allocation was focused on stock/government bond decision. But the early 2000's brought a widening of opportunity sets, with regional equity and bond markets being added to the stocks/bonds/cash decision.
This grew further to take in individual equity markets, sector baskets and investment styles as well as FX strategies, comprising the G10 developed currencies as well as emerging markets, plus commodities. Today, our tactical asset allocation process covers all of the main equity, government bond, credit and currency markets and potentially assets that are not held strategically in the fund. The process is designed to focus on identifying mispriced opportunities. In most instances the team look for "episodic or fundamental market events". The tactical investments the team make are often only held for between three and six months.
"Our overriding tactical asset allocation investment philosophy is to not take on a position unless we believe there is a significant mispricing or an enduring opportunity that has a high likelihood of being rewarded. We do not make decisions on a day-to-day basis. Therefore we typically have significantly fewer active positions on at any point in time compared to many global tactical allocation or macro hedge funds," explains Butler.
However, the team has implemented a number of tactical allocation decisions this year. Take the first quarter of 2018, when parts of the equity market saw large drawdowns as valuations came under pressure. Volatility returned with a vengeance, yet there was little negative economic data driving the falls. Because of this, Butler took a decision in early February to increase risk assets in the multi-asset portfolio range.
This allowed the group to benefit from the market rally that followed at the end of the month and take profits. A similar train of thought followed the group’s view on Italy’s equity markets, which have taken a hit amidst election turmoil in Q1.
Widdows adds “Italy and Turkey are two markets we’ve been taking a close look at increasing exposure in recently as we saw investor beliefs reacting to news flow and pricing potentially overshooting. We also look at areas where contagion appears to be happening even though underlying fundamentals haven’t changed and again these can be opportunities presented because of investor behaviour.”
PPMG portfolios periodically reset their strategic asset allocations too, to incorporate latest information on long-term return, risk and liquidity expectations. These regular reviews also allow new asset classes to be incorporated as they become viable. The evolving strategic allocation and the tactical element is a modern approach to multi-asset investing and somewhat unique in the industry.
On the one hand the industry has passive funds with fixed weights or those that align themselves with a composite benchmark and rarely ‘reset’ portfolio allocation. Active managers on the other hand often choose to pick the best asset class they believe will outperform in a given time period.
"We believe we can generate long-term returns by being diverse and providing exposure across multiple asset classes and regions. But at the same time, we know markets are not always rational and there will always be opportunities to exploit. We benefit from having two separate teams focusing on the distinct asset allocation processes, as well as utilising underlying fund managers who are the specialists in their own specific asset classes. We have multiple ways of adding value for our investors," says Widdows.
The tactical allocation process can often be contrarian in nature, although this is not the main purpose of Butler’s tactical investing style.
"One of the advantages of working with large, growing funds and taking a long-term approach is that we are able to take contrarian views when we believe that is appropriate. We are able to take, at times, a view against what the wider market is doing and hold it for a period of time. However, we are also trying to remove excesses. So for example when we believe markets have become overly valued we want to try and protect our portfolios on the downside as well. We are very cognisant of drawdown risk as we are aware that stability of income is extremely important to multi-asset investors today."
Despite this a tactical asset allocation process should not, says Butler, be based only on risk management "A lot of questions we receive from investors is how we protect the portfolio on the downside when tactically allocating, and the truth is we don’t aim to do that. Risk management is inherent in the process, however. We incorporate significant amounts of diversification and minimise the chance of a single position or risk impacting the portfolio adversely. We also consider the risk impact of every tactical decision we make. The team is constantly focused on risk management and works with our independent risk function."
"We abide by strategic asset allocation that guide our portfolios on a long-term basis but aim to add value in the shorter term where we can," says Butler
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