The Rise of Tactical Allocation

Portfolio construction has typically relied on strategic asset allocation to help control volatility.  The idea is that if you combine assets with low correlations, you can significantly reduce the volatility of your returns.  Lately, however, correlations have become a problem.  Jeff Benjamin, writing in Investment News, discusses the problem:

Asset classes have become so highly correlated over the past few years that many traditional diversification strategies have lost their effectiveness.

For example, take the link between growth and value stocks.

For the decade ended December 2000, the correlation between the Russell 1000 Growth Index and the Russell 1000 Value Index was just 57%. During the decade ended this past December, it jumped to 92%.

For a more extreme case, compare the correlation of the MSCI Emerging Markets Index with the Russell growth index. The former was negatively correlated to the latter by 6% — which was great for those seeking diversification — in the decade through December 2000, but the correlation spiked to 89% in the following decade.

You can see the issue—drastically changing correlations will move your efficient frontier far from where you imagined it was.

Some of the observers Mr. Benjamin quoted were blunt:

“Traditional diversification is like a seat belt that only works when you’re not in a car accident,” said Michael Abelson, senior vice president of investments at Genworth Financial Wealth Management Inc.

“Depending on risk tolerance, we might recommend allocating half a portfolio to a diversified strategic strategy and then 30% to 35% to a tactical strategy and 15% to 20% to alternatives,” Mr. Abelson said.

Besides having a knack for a fine turn of phrase, Mr. Abelson mentions something that we have noticed more and more in recent years.  It used to be the case that tactical allocation was used as a satellite strategy and might get only a 10% slice of a portfolio.  Now, we often see the tactical strategy with a 35-50% weight.  Some advisors are even using the tactical allocation as the core strategy and arranging alternatives and other asset classes as strategic overweights.

With the rise of tactical allocation come new challenges.  Chief among them is how to manage the tactical portion of the portfolio.  All-in/all-out timing decisions are notoriously difficult to get right.  Overweighting and underweighting based on valuation requires sophisticated modeling that must be constantly updated.  In addition, many assets are resistant to traditional valuation methods.

One method that does work over time is tactical asset class rotation using relative strength.  We’ve chosen that path for our Global Macro strategy because it allows a very large and diversified universe to be ranked on the same metric.  That, and because it works.

Click here and here for disclosures.  Past performance is no guarantee of future returns.

One Response to The Rise of Tactical Allocation

  1. […] When I read articles like this, it makes the argument that some type of global macro strategy needs to be part of a core portfolio.  We no longer have the investment luxury of staying completely within our borders, figuring that the best returns available can be captured here.  The world is changing and global is the new core. […]