Uses of Short-term Shifts in Asset Allocation

Uses of Short-term Shifts in Asset Allocation

Strategic asset allocation (SAA) is the predetermined distribution of assets in a portfolio based on long-term goals and is established in an investment policy statement (IPS). On the other hand, tactical asset allocation (TAA) involves making short-term adjustments to the SAA, typically for capitalizing on specific market opportunities. These adjustments are temporary and usually last for up to one year.

Market Opportunities

Tactical asset allocation (TAA) primarily aims to enhance risk-adjusted returns. Competent portfolio managers utilize TAA strategies to mitigate risk during market volatility or exploit market anomalies to achieve additional returns. The following examples of TAA approaches may be familiar to level III candidates who have already been exposed to different investment styles.

(Discretionary) Qualitative Approach

This approach relies on the manager’s judgment and analysis. Macroeconomic variables such as forecasted GDP, inflation, and risk premiums are considered to identify potential short-term mispricing of securities or asset classes. For instance, if a manager anticipates a larger-than-expected decrease in inflation in the coming year, they may increase the portfolio’s allocation to fixed income. The investment policy statement (IPS) sets predefined ranges or limits on the extent of asset class shifts allowed for TAA. For example, the manager might have the flexibility to deviate up to 15% from the strategic asset allocation (SAA) to capitalize on perceived opportunities. 

Market sentiment is another form of discretionary TAA in which a manager attempts to time the market by following a trend.

  • Short interest: This refers to the number of investors who have taken short positions on a particular security. High or increasing short interest is generally seen as a bearish signal.
  • Open options interest: This metric calculates the number of open options positions initiated by investors. These positions represent options contracts not closed through an offsetting trade or exercise/assignment. An accumulation of call options indicates a bullish sentiment, while a buildup of put options suggests a bearish sentiment.
  • Volatility indexes: These indexes measure the level of fear or market uncertainty. A well-known example is the CBOE’s VIX. Higher readings on volatility indexes typically indicate investor pessimism.
  • Index moving averages: This technique involves tracking the average values of indexes over a specific period, such as 200 days. It is considered a bullish sign when shorter-term moving averages surpass longer-term moving averages. Conversely, if short-term moving averages decline, it is interpreted as a bearish signal.

(Systematic) Quantitative Approach

In contrast to the qualitative approaches discussed earlier, quantitative approaches typically rely on employing models to make investment decisions. These models generate binary recommendations: either to invest or not to invest based on predefined criteria.

  • Value approach: The value approach focuses on capturing return premiums by targeting undervalued stocks. It involves conducting fundamental analysis to identify mispriced stocks and taking long positions in those undervalued while potentially shorting overvalued stocks.
  • Growth/momentum approach: This strategy assumes that trends continue over time. It involves identifying the strength and direction of a security’s movement and making investments based on the expectation that the trend will continue. Fundamentals are not considered in this approach.

TAA Performance Evaluation

Methods for evaluating the success of a tactical asset allocation (TAA) decision may include:

  • Comparing the Sharpe Ratio of the strategic asset allocation (SAA) and the TAA component of the portfolio.
  • Utilizing the information ratio or t-stat ratio to compare the performance of the TAA portion relative to the SAA portion.
  • Analyzing the realized risk and return of the TAA portfolio and comparing it to portfolios located on the efficient frontier.
  • Conducting attribution analysis on the excess return generated by the TAA strategy.

Question

Which of the following is least likely a qualitative approach to TAA?

  1. Following open interest.
  2. Using volatility indexes.
  3. Adopting a value bias.

Solution

The correct answer is C.

A value-based decision involves buying stocks in a specific sector when their market price is lower than the value indicated by the advisor’s model. Adopting a value bias is the least likely to be considered a qualitative approach to TAA. A value bias entails quantitatively analyzing fundamental factors and valuation metrics to identify undervalued stocks or assets. It focuses on objective criteria rather than subjective or qualitative factors. Therefore, option C is not a qualitative approach to TAA.

A and B are incorrect: Qualitative approaches to TAA include following open interest and using volatility indexes. Unlike value tilt, which allows for clear buy and sell decisions based on objective criteria, these qualitative approaches rely more on subjective analysis. They may not provide definitive guidelines for trading actions.

Asset Allocation: Learning Module 5: Asset Allocation with Real-World Constraints; Los 5(d) Discuss the use of short-term shifts in asset allocation

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.