Asset Allocation Strategies
Approaches to the asset allocation process
Asset allocation strategies can be active to varying degrees or strictly passive in nature. How often should the allocations of an investor’s optimal portfolio be reviewed depends on the investor’s goals, age, market expectations and risk tolerance. In portfolio construction, this spectrum is generally divided between strategic asset allocation (SAA), tactical asset allocation (TAA) and dynamic asset allocation (DAA).
Strategic Asset Allocation (SAA)
An investor’s aversion to risk is expected to be a long-term trait. Thus, the resulting optimal portfolio should be relevant for the long term. Strategic asset allocation is a strategy whereby once the target allocations for various asset classes are set, no further decisions need to be made and the portfolio allocations are managed in a passive manner.
This does not mean that the portfolio can be run without any further intervention. In order to implement an SAA approach, it is important to determine the rebalancing policy. As time goes on, a portfolio will naturally drift from its benchmark allocations – asset classes with higher expected returns will take up a larger allocation as opposed to lower returning asset classes. Hence, the portfolio is rebalanced to the original allocations when these deviations are significant.
Tactical Asset Allocation (TAA)
Tactical asset allocation involves adding a layer of decision-making and activity on top of the SAA based on perceived changes to investment performance. In the short-term, factors can drive prices up or down, temporarily changing out estimates for return or risk. The premise of TAA is to assess short-term deviations from long-term capital market expectations and apply the allocations to a portfolio temporarily in order to capitalise on unusual or exceptional investment opportunities. This flexibility adds a market-timing component to the portfolio, allowing you to participate in economic conditions more favorable for one asset class than for others.
In producing temporary shifts away from the SAA, an investor might also set a TAA policy to determine how far away from the benchmark the tactical allocation is allowed to move. This strategy demands some discipline, as you must first be able to recognize when short-term opportunities have run their course and then rebalance the portfolio to the long-term asset position.
Dynamic Asset Allocation (DAA)
Dynamic asset allocation involves constantly adjusting the mix of assets as markets rise and fall, and as the economy strengthens and weakens. The aim is to achieve returns that exceed a targeted benchmark. DAA relies on a portfolio manager’s judgement instead of a target mix of assets. The success of this strategy depends on the portfolio manager making good investment decisions at the right time.
Overall, the decision to adopt either of these approaches will general come down to a few factors including:
- Cost of added activity – the greater the level of active management, the greater the amount of decisions that need to be assessed and made and the greater the cost associated with managing the portfolio. This cost needs to be weighed against expected benefits (greater returns, lower risks).
- Trust in management skill – the greater the trust in the skill of the investment manager, the more likely that an active management approach will be appreciated.