By: Robert J. Gordon, CFP®, AIFA®
Two thousand and eight was a remarkable year. Equity markets, commodity markets and corporate debt markets declined in unison leading many market pundits to challenge the veracity of diversification. That was populism at its worst! Remember, the media is about selling magazines, newspapers and programming and cannot be relied upon for well-reasoned financial and investment planning advice. That said, it probably makes sense to briefly review two philosophies regarding the creation and maintenance of investment portfolios: strategic and tactical asset allocation.
Before we jump into the details, let’s define a few key terms:
Diversification – In the case of an investment portfolio, this term refers to investing in different and non-correlated assets with the objective of lowering the risk related to an investment portfolio.
Asset or asset class – Investopedia defines an asset class as a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). Additionally, some professionals also include commodities and real estate as separate asset classes.
Asset allocation – This refers to the specific, asset by asset proportional representation in a portfolio. The objective is to create a portfolio whose risk and return characteristics coincide with the objectives and constraints of the investor.
Rebalancing – Buying or selling asset classes which, due to market price fluctuations, no longer comply with the original target proportions within a portfolio. Typically, target ranges or values are set to trigger the rebalancing exercise which take into consideration the costs of rebalancing.
Strategic asset allocation describes the practice of creating a portfolio with a mix of assets designed to fit the investment parameters of the investor. A key assumption is that those parameters will remain relatively stable over the long term. In other words, if the investor’s long term objectives and risk tolerance are best served by a 60% equity and 40% fixed income portfolio (this will have been determined through a rigorous investment and financial planning review) then that will be set as their target portfolio until their investment objectives and risk tolerance change significantly (i.e,. win the lottery, retire, disability or any other change that renders the previous plan impossible or impracticable.) Because asset prices fluctuate, investors and investment managers would set criteria for rebalancing to the preset targets for the balance between fixed income and equities as well as for the individual asset classes within each of those larger categories. Strategic asset allocation is frequently referred to as buy-and-hold investing. This is inaccurate since great care is exercised to make sure that the asset to asset proportions remain stable despite market fluctuation which requires periodic rebalancing. Buy-and-hold typically suggests that after the initial investments, no changes are made for rebalancing regardless of market price fluctuations.
Tactical asset allocation essentially takes a strategic asset allocation and regularly adjusts it for changing market conditions subject to forecasts, whims or guesses. The premise is that by doing this, one can optimize market exposure to best maximize risk-adjusted returns. It relies on forecasting skill and adroit execution. Let’s assume that you are an investor who, on December 31, 2007, had a portfolio that stood at 80% equities and 20% fixed income. There were no withdrawals from this portfolio and no cash inflows. By the end of 2008, your portfolio was probably closer to 60% equities and 40% fixed income due the dramatic decline of equity prices throughout the year. If the strategic asset allocation target called for an 80% equity/20% fixed income ratio, then, under the guidelines for strategic asset allocation, the investor would rebalance the portfolio to the policy asset allocation of 80% equities and 20% fixed income by selling fixed income and using those funds to buy equities. However, if an investor was practicing tactical asset allocation, they might decide that the market recovery will be strong and they wish to temporarily move the equity allocation to 90%. Hopefully, the investor or investment manager has some preset parameters to judge whether or not he is right and when to go back to the long term strategic allocation. Portfolios utilizing tactical asset allocation are exposed to two primary performance drags: inaccurate forecasts (i.e. bad market calls) and trading costs.
Considering the mountains of studies which declare that active investment management adds NO value, it is foolhardy to consider tactical asset allocation as anything more than a bet. Standard & Poor’s, the rating agency, recently published the update to their S&P Indices Versus Active Funds (SPIVA) scorecard report. According to this report, benchmark indices outperformed a significant majority of actively-managed equity and fixed income funds. The primary difference between strategic and tactical asset allocation comes down to active investment management and the belief that it is possible, over a long period of time, to beat’ the market.