Tactical Asset Allocation

Institutional investors often employ an active risk budget, typically gauging how much their portfolio deviates from the investment policy targets annually, often as a tracking error limit.

This limit might be increased to seek higher returns or decreased to reduce volatility.

If the investment policy statement (IPS) allows it, derivatives can be a useful tool for adjusting the tracking error limit.

Tactical asset allocations (TAA) involve temporary shifts from the stated asset allocation to potentially outperform the original portfolio.

Rebalancing is the process of realigning asset allocations when they drift too far from their targets.

In all these scenarios, the use of derivatives could be considered.

Tactical Asset Allocation

Through either fundamental or quantitative analysis, or some combination thereof, investment managers will create their investment thesis. This thesis is often based on management expertise and quantitative models with predictive power. An example of a thesis could be that global large-cap companies are currently undervalued based on a DCF analysis, and mean-reversion could be expected within the year. Based on this, the manager might adjust the normal portfolio asset allocation as follows:

+2% Global Large-Cap Equities (Overweight)

This does not mean the manager needs to purchase (2% x portfolio value) worth of global large-cap equities. Three potential options to implement the decision could be:

1. A total return swaps.
2. Equity futures.
3. ETFs.

The goal is to implement the overweight position as effectively as possible from a cost and cash usage perspective. The following is an example of a cost comparison analysis that could help a manager look at the different options available and decide which is best:

$$ \begin{array}{l|r|r|r}
\textbf{Cost Component} & \textbf{ETF} & \textbf{Futures} & \textbf{TR Swap} \\ \hline
\text{Commission (round trip)} & 4.00 & 2.00 & 5.00 \\ \hline
\text{Management fee (annual)} & 3.50 & 0.00 & 0.00 \\ \hline
\text{Bid/offer spread (round trip)} & 2.50 & 2.00 & 6.00 \\ \hline
\textbf{Total} & 10.0 & 4.0 & 11.0
\end{array} $$

This analysis is predicated on the idea that the team would fulfill the mandate of 2% of the entire portfolio value, invested in large cap global equities, and displays a hypothetical cost using each of the various derivatives instruments.

Other Considerations

The ETF position should be fully funded, requiring the entire 2% of the portfolio's value to be used. Margin accounts might provide some offset, but they have limitations that prevent a 100% margined position. This makes the ETF option inefficient in terms of cash usage. Futures and total return swaps can offer similar economic exposure to ETFs with much lower capital requirements.

From a liquidity standpoint, ETFs and futures are efficient due to their liquid trading and narrow bid-ask spreads. They also offer flexibility for managers to end exposure before intended maturity if market views change.

However, holding futures has operational implications, requiring daily margin requirement monitoring and exposure to interest rate and counterparty credit risk in total return swaps.

Managers also consider opportunity costs. Tying up capital in investments means forgoing potential interest earnings in an account like LIBOR. This factor can significantly impact the perceived cost-effectiveness of ETFs, even if they were not initially the most expensive option.

Rebalancing

Institutional portfolios need to keep an eye on their asset allocations to ensure that they do not drift too far away from target allowances. To allow the allocation to drift is to inadvertently state a change in ability and willingness to rake risk in the financial markets. Rebalancing schemes can be time-related, such as rebalancing back to the target weights every month, or they can be stated corridors, such as a deviation of plus or minus 5% allowed for a particular asset class. The following table shows an example of a target asset allocation schedule with a corridor width rebalancing scheme:

$$ \begin{array}{c|c|c|c|c}
& \textbf{Target} & \textbf{Corridor} & \textbf{Min/Max} & \textbf{Current} \\ \hline
& \textbf{Allocation} & & & \\ \hline
\textbf{Asset Class} & \textbf{(SAA)} & & \textbf{Target} & \textbf{Allocation} \\ \hline
\textbf{Cash} & 1\% & \pm 1.0\% & 0\%–2\% & 0.80\% \\ \hline
\textbf{Fixed Income} & 6\% & \pm 3.0\% & 6\%–12\% & 11.0\% \\ \hline
\textbf{Domestic Equity} & 15\% & \pm 2.5\% & 12.5\%–17.5\% & 15.3\% \\ \hline
\textbf{International} & 9\% & \pm 2.0\% & 7\%–11\% & 6.00\% \\
\textbf{Equity} & & & &
\end{array} $$

The table demonstrates that, based on the desired allocations, fixed income is above the target allocation at 11%, while international equity has fallen below its permissible minimum value of 7%.

This means the portfolio manager will need to reduce exposure to fixed income while increasing exposure to international equity. Managers may consider the following factors: transaction costs, tracking error of the implementation vehicle versus the desired index exposure, tracking error implied by the current and post-rebalancing deviations from the target SAA weights, opportunity cost/impact to active strategies due to manager withdrawals and reallocations, implementation speed, and time horizon of the rebalancing trade. Executing through the cash markets takes longer to implement than executing in the derivatives markets. Still, allocating to, or reallocating from, external managers may be warranted in certain cases, such as when the adjustments are viewed as more permanent and/or more significant in nature.

Question

Potential rebalancing tools highlighted in this section included?

1. Swaptions.
2. Equity forwards.
3. ETFs.

Solution

The correct answer is C.

This section reviewed total return swaps, equity futures, and ETFs as potential rebalancing or tactical asset allocation tools.

Portfolio Management Pathway Volume 2: Learning Module 7: Case Study in Portfolio Management: Institutional;

Los 7(e) Analyze the costs and benefits of derivatives versus cash market techniques for establishing or modifying asset class or risk exposures

Los 7(f) Demonstrate the use of derivatives overlays in tactical asset allocation and rebalancing