The Hindu Business Line : Strategic versus tactical asset allocation

The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework to seek an additional source of return.

Jaideep Hansraj

Most investments tend to do well with no apparent science in bull phases. But the science of investing comes to the fore while managing investments either in a bear phase or in times of extreme volatility.

Different asset classes may peak at different times offering fantastic potential for multi-bag investing. At these times the investor faces tremendous pressure to go overweight in certain sectors leading to a misbalance in their portfolio. Such a port folio, while outperforming in good times, underperforms under less sanguine circumstances. These situations may also result in substantial erosion of capital.

No asset class has singularly outperformed over the long run, whether it was the bond funds that were at their best best in 2000 and 2001 or mid-caps in 2002, 2003 or 2004 or the Sensex in 2005 and 2006.

Diversification is the practice of spreading money across various investment segments to reduce risk. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuation of investment returns without having to forego potential gains.

Base policy mix

Strategic asset allocation is a diversification method that establishes and adheres to a ‘base policy mix’. This is a proportional combination of assets based on expected rates of return from each asset class. For example, if stocks have historically returned 10 per cent per year and bonds have returned 5 per cent per year, a 50:50 mix of bonds and stocks would be expected to return 7.5 per cent per year.

There are many ways of achieving a base policy mix with diversification acting as the guiding principle. However, diversification as a concept has existed for long in the minds of investors.

Many of us would know about the perils of putting all the eggs in one basket. Therefore, more than the idea of diversification, it is important to arrive at an objective method of scientifically diversifying in order to obtain the most efficient risk-return combination in the form of the best base policy mix.

This scientific method of arriving at the most efficient risk-return combination is defined by Markowitz’s Mean Variance Optimization Model known more popularly as Modern Portfolio Theory. Every possible asset combination can be plotted in the risk-return space, and the collection of all such possible portfolios defines a region in this space. The line along the upper edge of this region is known as the efficient frontier (sometimes ‘the Markowitz frontier’).

Simply put, the science is to select the portfolio which either holds the least amount of risk, given the return or to take the best possible return given a level of risk. The model assumes that investors are risk-averse, meaning that given two assets that offer the same expected return, investors will prefer the less risky one.

Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics.

Tactical changes

Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, it may be necessary to engage in short-term, tactical deviations from the mix in order to capitalise on unusual or exceptional investment opportunities.

This flexibility adds a component of market timing to the portfolio, allowing the investor to participate in economic conditions that are more favourable to one asset class than for others.

The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework to seek an additional source of return. An attempt is made to take advantage of short and intermediate term market inefficiencies as a means of managing investors’ exposure to market risk.

The investment philosophy is usually based on the belief that investor psychology and market forces can lead to periods of misevaluation. A tactical allocation process attempts to capture these misevaluations.

Thus an investor would need to plan his investments across asset class and investment styles with a mix of offerings that are, in a combination, best suited for him. The portfolio would also need to be relatively flexible to take advantage of short-term opportunities.

Do ask your relations manager to help you understand the risk and the structure of your portfolio. She would need to understand your risk profile, risk-taking ability and past investments to get a holistic view. After all, diversifying assets is the key to stay wealthy .

(The author is Head, Wealth Management Services, and Executive Vice-President, Kotak Mahindra Bank.)

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