Clients Demanding Tactical Allocation

Advisor One had an article reprising the findings of the most recent Curian Capital survey of advisors.  Their results will not surprise anyone.

• Nearly two-thirds of the advisors say that they have begun using more tactical asset allocation strategies to mitigate economic volatility, and more than half of respondents report they are using more alternative investing strategies.

• As a result of market volatility, nearly 4 out of 5 advisors report an increase in their clients’ demands for more conservative investments; in addition, 72% say their clients have an increased demand for guaranteed income features, 55% report an increase in demand for more tactical asset allocation, and 47% report an increase in demand for alternative investments.

Clients want tactical allocation strategies.  This may be for diversification, but it may also be for risk mitigation, since strategic asset allocation didn’t help them much last time around.  (I added the emphasis above.)

I find the demand for more tactical allocation interesting for a couple of reasons.  Even ten years ago, tactical allocation was derided as market timing by hard core strategic allocation advocates.  Now clients are objecting to holding asset classes during a prolonged nosedive, whether it is in service of diversification or not.  There’s much more awareness of the risk inherent in strategic asset allocation given that we have gone through two bear markets in the last decade or so.

Now that everyone is a tactical asset allocator, the question really boils down to methodology.  What process are you going to employ to make your allocation decisions?  I will suggest that gut feel will get you in trouble almost immediately.  Relying on emotion is not a good way to go.  I think either valuation or relative strength methodologies will work in the long run, but they put different analytic demands on the allocator.

To run a valuation-based process, you need to have a reliable way of generating reasonably accurate expected returns for asset classes.  (Simply using past history will not work, as many strategic allocators discovered over the past decade.)  That’s not an easy task.  It requires a ton a relevant data and a lot of testing to make sure your forecasting process has some validity.  You’re still going to have a large margin of error, so your portfolios will never be optimal.  Paradigm shifts are still going to create major problems.

Relative strength offers a reasonable alternative.  You need to have a reliable ranking method for the assets included in your universe, but we like it because you don’t have to forecast.  Instead, you are relying on the ability of the process to cast out losers and adapt to new trends.

Valuation and relative strength don’t have to be mutually exclusive.  In fact, excess returns are typically negatively correlated.  This is just a fancy way of saying that the two strategies tend to perform well at different times.  Combining two tactical allocators, one using relative strength and one using valuation, is also a very good way to go.

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