Risk Management
Asset Allocation
Strategic Asset Allocation (SAA)
Strategic asset allocation is a portfolio strategy whereby the investor sets target allocations for various asset classes and rebalances the portfolio periodically.
The target allocations are based on factors such as the investor’s risk tolerance, time horizon, and investment objectives.
The portfolio is rebalanced when the original allocations deviate significantly from the initial settings due to differing returns.
In strategic asset allocation, the target allocations depend on several factors: the investor’s risk tolerance, time horizon, and investment objectives. Also, the allocations may change over time as the parameters change. Strategic asset allocation is compatible with a buy-and-hold strategy as opposed to tactical asset allocation, which is more suited to an active trading approach. Strategic and tactical asset allocation styles are based on modern portfolio theory, which emphasizes diversification to reduce risk and improve portfolio returns.
Suppose 60-year-old Mr. Sharma, who has a conservative approach to investing and is five years away from retirement, has a strategic asset allocation of 40% equities / 40% fixed income / 20% cash. Assume Mr. Sharma has a $500,000 portfolio and rebalances her portfolio annually. The dollar amounts allocated to the various asset classes at the time of setting the target allocations would be equities Rs. 2,00,000, fixed income Rs. 2,00,000, and cash Rs. 1,00,000.
In one year’s time, suppose the equity component of the portfolio has generated total returns of 10% while fixed income has returned 5% and cash 2%. The portfolio composition is now equities Rs. 2,20,000, fixed income Rs. 2,10,000, and cash Rs. 1,02,000.
The portfolio value is now Rs. 5,32,000, which means the overall return on the portfolio over the past year was 6.4%. The portfolio composition is now equities 41.3%, fixed income 39.5%, and cash 19.2%.
Based on the original allocations, the portfolio value of Rs. 5,32,000 should be allocated as follows: equities Rs. 2,12,800, fixed income Rs. 2,12,800, and cash Rs. 1,06,400.
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Tactical Asset Allocation
Tactical asset allocation is an active management portfolio strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors. This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace. It is a moderately active strategy since managers return to the portfolio's original asset mix once reaching the desired short-term profits.
Tactical asset allocation is the process of taking an active stance on the strategic asset allocation itself and adjusting long-term target weights for a short period to capitalize on the market or economic opportunities. For example, assume that data suggests that there will be a substantial
increase in demand for commodities over the next 18 months. It may be prudent for an investor to shift more capital into that asset class to take advantage of the opportunity.
Tactical asset allocation is different from rebalancing a portfolio. During rebalancing, trades are made to bring the portfolio back to its desired strategic asset allocation. Tactical asset allocation adjusts the strategic asset allocation for a short time, with the intention of reverting to the strategic allocation once the short-term opportunities disappear.
TAA strategies may be either discretionary or systematic. In a discretionary TAA, an investor adjusts asset allocation, according to market valuations of the changes in the same market as the investment. An investor, with substantial stock holdings, for instance, may want to reduce these holdings if bonds are expected to outperform stocks for a period. Unlike stock picking, tactical asset allocation involves judgments on entire markets or sectors. Consequently, some investors perceive TAA as supplemental to mutual fund investing.
Conversely, a systematic tactical asset allocation strategy uses a quantitative investment model to take advantage of inefficiencies or temporary imbalances among different asset classes. These shifts use a basis of known financial market anomalies, or inefficiencies, backed by academic and practitioner research.