Tactical asset allocation for US pension investors: How tactical should the plan be?

Abstract

Following the recession in the early 2000s, US corporate and public defined benefit (DB) plans faced unprecedented uncertainty with respect to their funding requirements going forward. Just as capital market performance started helping plan sponsors improve the health of their DB plans, the financial crisis of 2007–2009 delivered another serious blow. Consequently, plan sponsors turned their focus on improving their risk management practices and determining whether asset managers with proven track records should be given more broadly defined mandates, specifically designed to allow for more effective navigation in more volatile markets. Tactical asset allocation (TAA) strategies seek to add value by deviating from a plan’s policy mix based on the manager’s view on the attractiveness of various asset classes, regions and sectors within the investment opportunity set. Although TAA can add value to a portfolio, manager skill and risk taking are required to achieve reasonable risk-adjusted performance. The timing and magnitude of shifts from the policy mix can have a significant impact on the portfolio outcomes. Therefore, it is essential for investors to assess the appropriate role of TAA in their portfolio management process and evaluate the risk-return tradeoff of tactical deviations from policy. Our study uses a sample of historical returns from the global financial markets and simulation methodology to investigate the relationship of tactical band size and rebalancing practices to various measures of portfolio performance. The results show that providing investment managers with limited flexibility in making asset allocation decisions may allow DB plans to weather down markets better. For DB plan sponsors who are considering giving managers less constrained mandates, manager skill in adding value through TAA decisions should be considered.