TACTICAL ASSET ALLOCATION

Abstract

ate director at RogersCasey. omestic tactical asset allocation (TAA) gained popularity during the 1980s and 1990s as an important strategy for penD sion funds. By the end of 1994, institutional investors had committed $48 billion to domestic TAA strategies. A TAA manager’s investment objective is to obtain better-than-benchmark returns with (possibly) lower-than-benchmark volatility by forecasting the returns of two or more asset classes, and varying asset class exposure accordingly in a systematic manner. To minimize transaction costs, managers often use derivatives, primarily index futures, to implement decisions. Interest in TAA grew when evidence of the forecastability of stock and bond market returns appeared in the literature (Breen, Glosten, and Jagannathan [1989], Campbell [1987], and Fama and French [1988, 19891). Merton’s [19811 seminal work on measuring the performance of TAA, and the tests of timing skill derived from it in Henriksson and Merton [1981], Cumby and Modest [1987], and Pesaran and Timmerman [1992, 19941, then allowed investors to evaluate TAA strategies correctly for the first time. Unfortunately, there is little consensus on the reason for this forecastability. Competing explanations include the macro inefficiency of the domestic equity markets, particularly in the late 1970s (Modigliani and Cohn [1979] and Shiller [1984, 1989]), time-varying risk premiums (Campbell [1987], Fama and French [1988, 1989]), and the variation of investors’ risk toler-