Asset allocation strategies can be broken down into two major categories: strategic asset allocation and tactical asset allocation. Strategic asset allocation has the primary goal of providing the best risk/return balance for a long-term investment horizon by reducing the correlations between portfolio holdings through the diversification of asset classes (i.e., equities, bonds, commodities, real estate). Strategic asset allocation involves maintaining a constant ratio of these asset classes through rebalancing periodically, and can be described as a sort of “buy and hold” or “passive” approach to investing. Tactical asset allocation, on the other hand, provides an “active” management component to the portfolio, with the goal of allocating funds in a portfolio to asset classes that are expected to outperform the overall market. This approach requires a form of market timing through techniques such as technical and fundamental analysis, macroeconomic indicators, or regression analysis, among many more.
Strategic asset allocation is an effective strategy in most bull markets, as the low correlation of the asset classes in the portfolio provides strong returns while at the same time reducing overall portfolio volatility.
While asset class diversification may lead to reduced portfolio volatility on average, in times of crisis, correlations between asset classes spike in the positive direction, greatly reducing the benefit of strategic allocation and resulting in a portfolio drawdown comparable to a portfolio exposed to only one or two asset classes. To address this issue, tactical asset allocation should be incorporated in order to track asset class performance, signaling when the holdings of a particular asset class should be reduced due to a drop in price or increase in volatility. A widely-used approach to tracking asset class performance is through the use of moving averages to detect upward and downward trends in price movements. A moving average is the average price of a particular asset class or security over a designated period of time. For example, a 15-day moving average would take the sum of the closing prices of the previous 15 days and divide it by 15 to find the moving average for that particular day.
A common practice in incorporating moving averages into a strategic asset allocation portfolio is to invest only in asset classes where the price is at or above the asset class’ 15-day moving average. If the price of the asset class moves below the moving average, the money allocated to that asset class is either switched to a cash position or allocated proportionally among the remaining asset classes in the portfolio. This tactical (or “active”) management technique can lead to even lower portfolio standard deviation while maintaining similar annual returns, but perhaps the most noteworthy result of this technique can be seen in the maximum drawdown of the portfolio at any given time.
Tactical asset allocation can provide a significant premium when combined with strategic asset allocation. While passive investing has proven to be a robust strategy in bull markets, active investing can greatly assist portfolio performance in bear markets or in times of increased volatility, which lead to less certain results in a simple passively-managed portfolio.
Works cited: Combining Strategic and Tactical Asset Allocation, Gary Antonacci, February 1, 2010. http://ssrn.com/abstract=1693266
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