Tactical asset allocation is less straightforward than strategic asset allocation. Instead of choosing target (strategic) levels for different asset classes within a portfolio, tactical asset allocation looks to alter the asset mix based on the current economic environment. There are a number of factors that produce a variety of approaches.
It is well known that markets move in waves. As an example, stocks seem to grow (and recede) in fits and starts. Bonds, too, have good years and bad years. This shouldn’t be surprising, since the human brain seems to be wired to identify trends. Investors make decisions based on the trends they see and magnify the effect. It makes sense that, if a person is attuned enough to spot the good and bad markets, they could allocate their funds to the more profitable asset.
The efficient market hypothesis (which may be on its last legs, following the 2008 market meltdown) would characterize it as impossible to time the market. That would be true if markets instantaneously adapted to new information. But not only to they react over time, they tend to overshoot. Because of the momentum of the market, it’s theoretically possible to get in front of a wave.
It remains extremely difficult to predict the beginning or end of a wave, market minimums and maximums. Any experienced value investor can relate an anecdote of cheap stocks getting cheaper. The same difficulty applies to entire markets. The stock market appears cheap. Will it get cheaper or will valuations rise? Bonds appear expensive, with yields that are low relative to the past 10 years. Will yields rise and prices fall? The questions are rhetorical because the timing of a change in momentum is unpredictable.
When tactical asset allocation is left up to an investment manager, usually at a pension fund or a mutual fund, they look at macroeconomic indicators, relative value and investor sentiment. (Unless they are superstitious and use technical analysis.) They apply their knowledge, their experience and their discipline to make a call. Generally, however, they don’t want to stray too far from the benchmark. If they’re wrong, they impose opportunity cost on the fund, in addition to the trading and tax costs that come from increased transactions. Most funds have flexibility to move up to 15% from the strategic asset allocation, but in practice this level is rarely reached.
Almost all tactical asset allocation mutual funds under perform their benchmark. But that doesn’t debunk the strategy, only the way it’s implemented by these mutual funds. I apply tactical asset allocation very differently. First, I use a relative strength formula. This system removes the guesswork and my own imperfect judgement. Because I invest in individual stocks, for income, I don’t use this approach in all my accounts. But within my non-taxable accounts, I invest 100% in a single asset class (index ETF). When the momentum of another asset class overtakes the one I own, I switch 100%. Because portfolio performance is augmented by asset class outperformance less costs, I want to capture all outperformance while minimizing trades. This all-or-nothing approach is markedly different from a mutual fund, where the trading costs (in practice) seem to outweigh any outperformance captured.
Tactical asset allocation is simple, but it’s not easy. Human nature causes us to want to be active at the wrong times, buying something that’s popular and selling after an investment has shown to be a dud (buy high, sell low). Tactical asset allocation requires a system that removes the emotion and simplifies the buy and sell signals. Because of the increased activity, the outperformance must outweigh the costs. In order to make bold trades, confidence must be very high.