Asset allocation — the process of allocating investment capital to assets classes — is important for investors to achieve investment objectives. Several readers in the recent past asked us if they should adjust their allocation policy to short-term market movements. Their question assumes relevance given the 25 per cent decline in bellwether indices from its 2010 highs. Such price decline can prevent the investor from reaching her investment objectives. The question is: Can individuals adjust their asset allocation policy to moderate risks due to short-term price declines?

This article explains strategic asset allocation. It then shows how individuals can use tactical overlay strategy to moderate the risk on the strategic core due to such short-term price declines.

Strategic asset allocation is tailored to help an investor reach her investment objectives. Consider an asset-class portfolio with stocks, bonds and commodities. An investor may want 55 per cent exposure to equity, 35 per cent to bonds and 10 per cent to commodities, primarily gold. The strategic asset allocation policy typically provides a range to define the preferred allocations. The allocation could, thus, be 45-65 per cent for equity, 25-45 per cent for bonds and 0-20 per cent for gold. In essence, the asset allocation policy provides 10 percentage points flexibility in the asset class exposure.

Investors can take advantage of this allocation range to moderate risks in their strategic core during market declines.

Tactical overlay

Tactical asset allocation complements strategic asset allocation in helping achieve investment objectives. It helps an investor take advantage of short-term drifts in asset prices from their long-run averages.

Let us say the market trades at a price-earnings multiple (PEM) that, according to the investor, is lower than its long-run average. The investor may decide to take equity exposure if she believes that the PEM will revert to its long-run average. Similarly, an investor can set-up a short position if she believes that current PEM is higher than its long-run average.

If the investor's view on the market turns correct, profits from such short-term movement will help moderate any unrealised losses in the strategic core portfolio. This strategy is called tactical overlay because it is laid on top of the strategic core.

It is important that investors adopt the overlay strategy within the range provided for strategic allocation to contain portfolio risk within the investor's risk tolerance level.

The question is: How should investors set up the tactical overlay strategy?

Two factors play an important role in successful adoption of a tactical overlay strategy. One, the investor should have an opinion on the market movement. This could be formed through self-analyses or provided by external research reports. And, two, the investor should have room within the strategic allocation range to invest in equity.

The investor has to decide on how to take short-term equity exposure. Such exposure should be on an actively traded index: The investor is betting on short-term movement in the broad market, not on individual stocks.

Overlay strategies are typically set-up using index futures (Nifty for instance), as they are leveraged contracts and require less cash to initiate the position. Investors who do not prefer index futures can consider ETFs for two reasons. One, it is easier to understand and trade in ETFs. Two, ETFs are cheaper to trade, unlike mutual funds, which levy a penalty for early redemption of units.

Conclusion

The strategic core is exposed to risks due to short-term declines in asset markets. Tactical overlay strategies can be used to profit from such short-term price movements. This enables investors to rebalance the strategic core only for extreme price movements while moderating price risk through tactical overlay strategies.

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