It is unlikely that the initial optimal asset allocation will be applicable for the entire lifetime of any portfolio. In practice, it is common to reevaluate the allocation annually or if a change in goals, constraints, or beliefs suggests it is required.
The circumstances that might trigger a special review of the asset allocation policy can generally be classified as relating to a change in goals, a change in constraints, or a change in beliefs.
- Changes in business conditions affecting the organization supporting the fund and, therefore, expected changes in the cash flows
- A change in the investor’s personal circumstances that may alter her risk appetite or risk capacity
- Changes in the expected payments from the fund
- A significant cash inflow or unanticipated expenditure
- Changes in regulations governing donations or contributions to the fund
- Changes in time horizon resulting from the adoption of a lump sum distribution option at retirement
- Changes in asset size as a result of the merging of pension plans
Short-term Shifts in Asset Allocation
The long-term asset allocation specified in an investment policy statement is known as the strategic asset allocation (SAA). This represents the target asset weightings for the portfolio.
Short-term deviations, known as tactical asset allocations (TAAs), are typically used to take advantage of cyclical conditions in the market or a perceived mispricing in a given asset class.
The SAA policy portfolio is the benchmark against which TAA decisions are measured. Tactical views are developed and bets are sized relative to the asset class targets of the SAA policy portfolio. The sizes of these bets are typically subject to certain risk constraints. The most common risk constraint is a pre-established allowable range around each asset class’s policy target. Other risk constraints may include either a predicted tracking error budget versus the SAA or a range of targeted risk (e.g., an allowable range of predicted volatility).
The success of TAA decisions can be evaluated in a number of ways. Three of the most common are
- a comparison of the Sharpe ratio realized under the TAA relative to the Sharpe ratio that would have been realized under the SAA;
- evaluating the information ratio or the t-statistic of the average excess return of the TAA portfolio relative to the SAA portfolio; and
- plotting the realized return and risk of the TAA portfolio versus the realized return and risk of portfolios along the SAA’s efficient frontier.
Discretionary TAA is predicated on the existence of manager skill in predicting and timing short-term market moves away from the expected outcome for each asset class that is embedded in the SAA policy portfolio. In practice, discretionary TAA is typically used in an attempt to mitigate or hedge risk in distressed markets while enhancing return in positive return markets (i.e., an asymmetric return distribution).
Using signals, systematic TAA attempts to capture asset class level return anomalies that have been shown to have some predictability and persistence. Value and momentum, for example, are factors that have been determined to offer some level of predictability, both among securities within asset classes (for security selection) and at the asset class level (for asset class timing).