Excerpt
Index
1. Introduction
2. Development of Asset Allocation Methods
3. Description of Strategic Asset Allocation
4. Description of Tactical Asset Allocation
4.1. Elemental Shifting Rules
4.2. Portfolio Insurance
4.3. Best of n risky assets
4.4. Protect Spending
4.5. Distinction between Strategic and Tactical Asset Allocation
5. Strategic versus Tactical Asset Allocation
5.1. Evaluation of Strategic Asset Allocation
5.2. Evaluation of Tactical Asset Allocation
5.3. Which Asset Allocation Decisions does affect returns most?
6. Asset Allocation under High Uncertainty
6.1. The Difficulty of Forecasting
6.2. The Importance of Risk and Correlation
6.3. Taking Inflation into Account
7. Conclusion
List of Abbreviations
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Figures
Figure 1: Mean standard deviation diagram
Figure 2: Correlation between 12 U.S. industries
Tables
Table 1: Portfolio value with different rebalancing strategies
Table 2: Historical returns for different economic scenarios
Table 3: Predicted risk and returns for different economic scenarios
1. Introduction
Asset allocation strategies are a frequently discussed topic with increasing importance in times of crisis. Such strategies should prevent us from price deterioration in bad times and ensure high return potentials in good times. More and more tactical asset allocation funds emerge and promise better returns than simple strategy funds. They always try to be on the right market side, in up as well as in down phases. This seminar paper deals with some basic question about what strategic and tactical asset allocation is, when should it be used and if these strategies are appropriate in a highly uncertain environment like the current. It should give the reader a broad overview about the topic by referring to different accepted theories and studies. First the development of asset allocation methods will be described resulting in strategic and tactical asset allocation and an evaluation of them. Furthermore a link toward uncertain market conditions will be compounded.
2. Development of Asset Allocation Methods
Humans increase their utility by increasing their capital which can be used at some point in time to consume more. Thereby the objective of investing is to ensure that the return of capital after taxes is at least as high as the inflation rate to obtain the purchasing power of capital. Asset allocation should fulfill these goals and coincidently keep risk at an appropriate level (Darst, 2008). The cornerstone of asset allocation was led by Markowitz in 1952 with his mean-variance model. Markowitz considers three different assets: cash, bonds and stocks. Stock offer a higher return combined with higher risk, whereas bonds offer a lower return at lower risk (Markowitz, 1952). As long as they are not perfectly positive correlated an optimal mix between bonds and stocks exist at the tangential point between the “mixed position” and cash, as can be seen in Figure 1. The straight line between cash and tangential bond/stock portfolio illustrates the possible investments someone would choose only looking at return and variance. This straight line is called the efficient frontier (Campell and Viceira, 2002).
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Figure 1: Mean standard deviation diagram
Source: Campell and Viceira (2002)
Based on the mean-variance-model the term risk was extended by the term beta with the capital asset pricing model of Sharpe (1964). Beta measures the movements of an asset in relation to the market and thereby strongly depends on the correlation between them. Thus the optimal portfolio can be chosen somewhere on the capital market line (using standard deviation) or security market line (using beta) according to the risk aversion of the investor.
If asset allocation choices are only based on that theory, financial planning would be somehow redundant. Nevertheless individual influences, like tax rate, investment horizon, income and illiquid asset holdings do influence the choice of an optimal portfolio as well. A typical scheme of financial planning is to encourage young and/or aggressive investors to hold a higher proportion of stocks. Canner et al. (1994) have shown that prominent advisors like Merrill Lynch are following this scheme which is not in line with the theoretical prediction of a unique optimal portfolio. This is called the asset allocation puzzle. One obvious explanation for this puzzle may be that financial planner or advisor need to recommend different portfolio composition for various investors, otherwise they would have no right to exist. On the other hand the classical portfolio theory could simply be seen as not practicable, e.g. because aggressive investors are unable to lend at the risk free interest rate and invest along the efficient frontier shown in figure 1. The basic methods of asset allocation may not be perfect or realistic, as any other theory or model as well, but they provide a simple and helpful guidance how to structure the allocation of a portfolio in relation to investors with varying risk preferences. Anyhow these models are still used and recognized.
3. Description of Strategic Asset Allocation
In simple words: Strategic asset allocation (SAA) can be seen as an overall investment direction which chooses an optimal long-term portfolio according to the risk preferences of an investor. Thereby the portfolio composition is only adopted if investors risk profile changes, market conditions alter deeply or in specified longer time intervals (e.g. every year) (Darst, 2008). According to Sharpe (1987) SAA only considers few asset mixes (e.g. steps of 10% for different asset classes). It can be seen as a constant mix strategy, where transactions are only made after specific time intervals to offset the price changes of different assets and to recover the initial asset mix. In practice, as a starting point a simulation is run to calculate return and risk of each asset mix. This serves as decision guidance for the investor. These simulations are typically made by using constant returns, risk, correlations and market conditions (Sharpe, 1987). Thus, changes in the expected return of an asset do not change its share in the portfolio. The problematic of changing market conditions will be assessed later on.
SAA can also be seen as the policy of asset allocation. Apart from the above mentioned factors it should incorporate time horizon. This is especially important, because a low-risk strategy in the short term may be a high-risk one in the long term (Arrnott and Fabozzi, 1988). It is also necessary to ensure that the selected strategy is really in line with investor’s preferences and risk profile. Furthermore institutional or professional investors have to consider new possible investment opportunities, should pre-assemble investment procedures for different financial scenarios and have to choose suitable asset managers (Darst, 2008).
4. Description of Tactical Asset Allocation
Tactical[1] asset allocation (TAA) can be seen as both, a counterpart and an extension to SAA. TAA focuses on the day-to-day investment decisions. Its main issues are to evaluate, select, purchase, sell and monitor specific assets, to calculate their key figures and to decide if investments activities are still in line with the policy or not. This should be done by always satisfying the previously determined strategy (Darst, 2008).
Probably the first who came up with TAA products were Wells Fargo in the 1970s. Their first TAA product was quite simple by investing into more stocks than the normal mix if the additional return compared to bonds (“stock premium”) was more than 3.5% and vice versa. The success of this strategy in the first years led to many imitators (Lee, 2000). Some important strategies in TAA are elemental shifting rules, portfolio insurance, best of n risky assets and protect spending. Each of these categories has its different versions and models, which I want to describe here very shortly (Dichtl et. al, 2003).
4.1. Elemental Shifting Rules
Constant Mix-Strategy: The initial mix between assets should be restored periodically. The asset which performed better since the last adaption will be reduced and the worse performing will be bought. This strategy is not suitable for pro-cyclical markets, where its return would be lower than those of a simple Buy-and-Hold strategy (Perold and Sharpe, 1988).
Linear Investment Rule: It is like a Buy-and-Hold Strategy including leverage. In pro-cyclical phases those assets which increase in value will be bought multiplied by a factor higher than one. Suitable for in trend phases (Dichtl et. al, 2003).
4.2. Portfolio Insurance
These strategies should ensure that the portfolio does not fall below a specific value by simultaneously maintain some upward potential.
Dynamic Stop-Loss: The portfolio is invested in risky assets until a lower limit (floor) is hit. Afterwards a portion of the portfolio is reinvested into less risky assets. Different floors can exist and an investment backward into the riskier assets is also possible (Bird et al., 1988).
Synthetic Put: The basic idea is to protect the portfolio by buying a put-option (protective put). Suitable put-options with sufficient liquidity are rare. The payout structure of a put can be replicated by a so called synthetic put which dynamically invests between risky and “riskless”[2] assets (Dichtl et. al, 2003).
Constant Proportion Portfolio Insurance (CPPI): A floor has to be defined. The difference between the portfolio value and the floor is called cushion. The proportion invested in stocks is a multiple of this cushion. CPPI is performing poor in a flat market[3] environment. If the floor is hit, the whole portfolio has to be redistributed into the riskless asset. This procedure leaves nearly no more upward potential left, as long as a riskless asset can only have the return of the risk less interest rate. This can be seen as the major drawback of this strategy (Dichtl et. al, 2003).
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[1] Tactical and dynamic asset allocations are often used as terms of the same purpose. For simplicity reasons this paper only uses the term tactical asset allocation
[2] The risk free interest rate or riskless assets are only a theoretical construct and do not exist. Government bonds of best rated countries can be seen as nearly risk free.
[3] Value of stocks does approximately stay at the same level
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