Tactical Allocation Research Articles

A New Measure of Tactical Allocation Skills in Performance Attribution Analysis

A New Measure of Tactical Allocation Skills in Performance Attribution Analysis

Analyzing Tail Risk Using Crisis Utility Rankings

In this paper, we put forth the notion of “Crisis Utility” as a way of estimating the tail risk of an asset or investment strategy. We believe that Crisis Utility is more functional than traditional, narrowly defined definitions of tail risk since it incorporates the concept of “resiliency,” or recovery rate, as well as the traditional concept of maximum loss potential. Our argument for the inclusion of resiliency comes from our observations of the recent credit crisis. During the depths of the crisis we observed (1) that allocations, particularly institutional allocations, were “sticky,” which is to say that investors either had trouble adjusting asset allocations or were not inclined to do so, and (2) high water marks, or the arrangement that allows investors to recoup losses before a manager can charge additional performance fees, proved to be a significant benefit for resilient strategies. In an environment of sticky allocations and high water marks, we feel that the resiliency of a strategy becomes an important allocation point, particularly for institutions seeking to make long-term, strategic allocations as opposed to short-term, tactical allocations. Our study shows that lower volatility, low correlation strategies have a demonstrably higher Crisis Utility Rating than higher volatility, high correlation strategies. Specifically, using the HFR dataset, we found the strategies with the highest Crisis Utility Ranking were Short Bias, Equity Market Neutral, our bond proxy, Relative Value (Total), Systematic Diversified, Merger Arbitrage, Convertible Arbitrage and Fund of Funds: Defensive. We anticipate that these strategies will receive a relative increase in allocations as investors adjust their allocation models to account for tail risk, all else being equal and free of constraint. We also analyze the VIX Index within our Crisis Utility framework and find that it handily outscores all other strategies in our study. Although it is currently difficult to find active long volatility managers, we conclude that this is an important area for growth.

Tactical allocation in commodity futures markets: Combining momentum and term structure signals

This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66%, respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, our double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. The abnormal performance of the combined portfolios cannot be explained by a lack of liquidity, data mining or transaction costs.

Tactical allocation of effort among multiple signals in sage grouse: an experiment with a robotic female

Males in many species have complex, multicomponent sexual signals, and there may be trade-offs between different signal components. By adjusting their signaling behaviors, males may be able to produce more attractive courtship displays in the face of these trade-offs, but this possibility has rarely been tested. In this study, we examined adaptive adjustment of display behaviors during courtship in a lek-breeding bird, the greater sage grouse (Centrocercus urophasianus). We measured the potential trade-off between display quantity (display rate) and quality (a temporal feature of displays) in a wild population of sage grouse using controlled approaches of a robotic female to experimentally induce changes in male display rate. We found that males who are more successful in mating can increase quantity without a decline in quality, with only unsuccessful males expressing an apparent trade-off. Male mating success was also positively correlated with responsiveness to changes in receiver distance, suggesting that successful males may avoid a trade-off by tactically adjusting their display rate—saving energy by displaying at low levels when females are farther away and at higher levels as females approach. Alternative explanations for this differential response to female proximity are discussed. Our results suggest that to be successful, males may need both the ability to produce attractive signals and the ability to effectively allocate their display effort by responding to female behaviors.

Is There Momentum in Cross-Sectional Anomalies?

This article examines the performance of Tactical Stock Allocation, which is based on anomalous behavior of stocks. Specifically, it uses the Fama and French [1993] Small-Minus-Big and High-Minus-Low factors and price-to-earnings ratio sorted returns over the period from 1970 to 2007 to characterize the anomalies. The authors find that a diversified strategy of tactical investing on these factors is capable of producing abnormal returns. However, tactical investing on the first two characterized anomalies is inferior to that of the price-earnings anomaly for the most recent period, thus implying changes in investors’ return-chasing behavior. Moreover, the evidence suggests that the anomalies related to the ratios exhibit momentum, and investors should invest in the best-performing anomaly of the month.

Commodity Forecasting for Tactical Asset Allocation

This analysis aims at developing forecasting models for both commodity volatility and commodity returns based on monthly data. I show that standard models of realized volatility are able to outperform both GARCH models and the random walk in terms of in-sample explanation power and out-of-sample prediction power. The volatility models that perform best are adapted from applications for other financial assets and different time horizons. These models are so flexible, however, that they can be adapted to forecast volatilities for time horizons important for tactical asset allocations. The return models developed here include seasonal and macroeconomic factors as explanatory variables for commodity returns and adjust for heteroschedasticity. They show similar explanatory power for past data than comparable return models used for equity returns or bond returns. While these models perform much better than random walk or standard time series models in-sample, the outperformance for one month out-of-sample forecasts is only marginally better than for a random walk model. These findings are similar to other asset classes like equity or FX markets. Since the models nevertheless provide some economic insight to what drives commodity returns, they are preferable to simple random walk or time series models. Further improvements to these models could be made using a multivariate environment but the relatively short history of data compared to the increasing number of free parameters of the models render this almost impossible in practice. Thus, the models described here are close to optimal both in terms of ex-post explanation power and ex-ante predictive power. They are easily estimated with standard statistical procedures, combine the latest findings of academic research and are sufficiently reliable to use as indicators for future asset returns and volatilities. Hence, they should provide added value to the development and implementation of a commodity strategy and a diversified strategy including commodities and other asset classes. When implemented to forecast other asset classes as well, the models provide can provide a unified framework to estimate future asset class and portfolio returns and risks and help in asset allocation decisions.

Global Tactical Cross-Asset Allocation: Applying Value and Momentum across Asset Classes

Global Tactical Cross-Asset Allocation: Applying Value and Momentum across Asset Classes

Tracking Problems, Hedge Fund Replication and Alternative Beta

As hedge fund replication based on factor models has encountered growing interest among professionals and academics, and despite the launch of numerous products (indexes and mutual funds) in the past year, it faced many critics. In this paper, we consider three of the main critiques, namely the lack of reactivity of hedge fund replication and its deficiency in capturing tactical allocations; its failure to apprehend non-linear positions of the underlying hedge fund industry and higher moments of hedge fund returns; and, finally, the lack of access to the alpha of hedge funds. To address these problems, we consider hedge fund replication as a general tracking problem which may be solved by means of Bayesian filters. Using the linear Gaussian model as a basis for discussion, we provide the reader with an intuition for the inner tenets of the Kalman filter and illustrate the results' sensitivity to the algorithm specification choices. This part of the paper includes considerations on the type of strategies which can be replicated, as well as the problem of selecting factors. We then apply more advanced Bayesian filters' algorithms, known as particle filters, to capture the non-normality and non-linearities documented on hedge fund returns. Finally, we address the problem of accessing the pure alpha by proposing a core/satellite approach of alternative investments between high-liquid alternative beta and less liquid investments.

Decentralized Downside Risk Management

The process of risk management for institutional investors faces two challenges. First, since most institutions are decentralized as opposed to being direct investors in assets, it is difficult to separate the risks of the assets in the portfolio from the risks generated by the investment decisions by the fund management to construct the portfolio. To address this issue, we propose a risk measurement methodology which calculates the risk contributions of individual securities and investment decisions simultaneously. This decomposition is applicable to any decentralized investor as long as its relevant risk measurement statistic can be additively decomposed. Second, statistics used to measure risk may not coincide with institution-specific investment risks, in the sense that the utility employed in asset allocation may be unrelated to the risk measure utilized. For example, an institution may do mean-variance asset allocation, but inconsistently measure the risk of the portfolio using Value at Risk. We apply this methodology to a particular type of decentralized investor, specifically, endowment funds where the relevant risk statistic is the downside risk of returns relative to actual payout levels, plus inflation. We show how downside risk can be decomposed and apply our simultaneous downside risk decomposition empirically on a sample of U.S. endowment funds. We find that an endowment's asset allocation to U.S. Equity, consistent with having the largest weight in the average endowment portfolio, generates about 50% of total endowment returns but almost 100% of total portfolio downside risk. We further find that tactical allocations (or timing) have economically small contributions to both returns and risk. Finally, we find that the allocations to U.S. Fixed Income and to Hedge Funds as well as active investment decisions (except for tactical) contribute positively to returns, while reducing portfolio downside risk. The risk contributions are sensitive to changes in payout levels and an increase in the latter may offset the risk reducing power of active investing.

Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes

Global tactical asset allocation (GTAA) strategies across a broad range of asset classes are explored in this article. In contrast to market timing for single asset classes and tactical allocation across similar assets, this topic has received little attention in the existing literature. The main finding documented in this article is that momentum and value strategies applied to GTAA across 12 asset classes deliver statistically and economically significant abnormal returns. For a long top-quartile and short bottom-quartile portfolio based on a combination of momentum and value signals, the authors report a return of 12% per annum over the 1986–2007 period. Performance is stable over time, is also present in an out-of-sample period, and is sufficiently high to overcome transaction costs in practice. The return cannot be explained by potential structural biases toward asset classes with high risk premiums, nor by the Fama–French and Carhart hedge factors. The authors argue that financial markets may be macroinefficient due to insufficient “smart money” being available to arbitrage away mispricing effects. <b>TOPICS:</b>VAR and use of alternative risk measures of trading risk, equity portfolio management, analysis of individual factors/risk premia

Tactical Allocation in Commodity Futures Markets: Combining Momentum and Term Structure Signals

This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66% respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, a novel double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. Interestingly, the abnormal performance of the double-sort portfolios cannot be explained by a lack of liquidity or data mining and is robust to transaction costs and to different specifications of the risk-return trade-off.

VIX as a Companion for Hedge Fund Portfolios

Volatility in general, and VIX in particular, is widely thought to influence hedge fund returns. This article shows that not only is VIX negatively correlated to hedge fund returns, the correlation profile is asymmetric with the correlation being more negative in negative months for hedge funds. When hedge funds are delivering the worst quartile returns, the diversification benefit is best. Equally interestingly, when the diversification or protection is least needed, i.e. in highest quartile months, the correlation is positive. It is explored whether a small allocation to VIX can be constructively used for risk reduction or downside protection in broad based hedge fund portfolios. Standard mean variance measures suggest a static allocation of 0% to 10%, which is consistent with the common sense approach of allocation only a very small portion of the portfolio to volatility. This range, together with the mean reverting property of VIX, and the asymmetric correlation of VIX and hedge fund returns is used to explore a tactical allocation strategy that outperforms a simple static allocation of VIX or a portfolio with no VIX allocation on a risk adjusted basis, while reducing downside risks.

Allocation d’actifs, variation des primes de risque et benchmarks

Asset allocation, changes in risk premia and benchmarks Asset allocation typically involves a two-step process with, first, a rigid strategic allocation, second, a time-varying tactical allocation whose performances are properly controlled through the use of benchmarks. This widely-accepted process, however, led most investors to be overly exposed to equity markets when they reached a peak in 1999-2000. It would be a mistake to consider that this overexposure was simply an unfortunate accident. In fact, it is an indication that this asset allocation process does not perform well when markets valuations are exposed to cyclical fluctuations. Since, these valuation cycles are unlikely to wane, a change in the asset-allocation process is in order. In particular, an improved process would render the strategic allocation more responsive to changes in assets’ relative valuations. Various solutions to the current crisis could be considered, differing in particular by the extent of the delegation granted to asset managers. JEL classification : G11, G12, G14

Tactical Style Allocation—A New Form of Market Neutral Strategy

Tactical Style Allocation—A New Form of Market Neutral Strategy

Predictability in Hedge Fund Returns (corrected)

A significant amount of research has been devoted to the predictability of traditional asset classes, but little is known about the predictability of returns emanating from alternative vehicles, such as hedge funds. We attempt to fill this gap by documenting evidence of predictability in hedge fund returns. Using multifactor models for the return on nine hedge fund indexes, for which the factors were chosen to measure the many dimensions of financial risk, we found strong evidence of significant predictability in hedge fund returns. We also found that the benefits of “tactical style allocation” portfolios are potentially large. We obtained even more spectacular results for an equity-oriented portfolio that mixed traditional and alternative investment vehicles and for a debt-oriented portfolio that mixed traditional and alternative investment vehicles. These results do not seem to have been significantly affected by the presence of reasonably high transaction costs.

Strategic and Tactical Allocation to Commodities for Retirement Savings Schemes

We examine whether the variance risk of investment portfolios of pension schemes investing in traditional asset classes can be reduced by extending the set of traditional investment opportunities with commodities. We investigate the economic and statistical significance of shifts in the strategic (three year), myopic (quarterly), and tactical (quarterly rebalancing) mean-variance frontier for pension schemes with a fixed liability portfolio. We find substantial differences in optimal strategic allocations for pension schemes with nominal and inflation-indexed pensions. While our results suggest that commodities reduce the risk on the funding ratio from an inflation-indexed scheme more than 30 percent, the optimal expected return and risk trade-off is unaffected for pension schemes with nominal claims. Similar results are obtained for the unconditional myopic investor with a quarterly investment horizon. When conditioning information about the macro economic situation is used, a pension scheme with nominal claims can during certain periods also improve its efficient risk-return trade-off by investing in commodities. Moreover, we investigate the use of quarterly timing strategies switching between commodities and stocks, in addition to the buy-and-hold investments in the traditional assets and commodities. Both for nominal and real pension schemes, timing strategies can be useful in addition to the strategic allocation. The liability hedging property of commodities is likely to reduce the probability of underfunding.

Strategic and Tactical Allocation of Municipal Bonds in Private Client Portfolios

In the current market, municipal bonds offer attractive after-tax yields combined with high credit quality and low price volatility, but investors' heavy use of munis in short-term tactical allocations (such as crossover trades) has added volatility to the market in recent years. Given the probability of yield-curve flattening and a return to a more normal short-term/long-term yield spread, investors should consider a barbell strategy in which the portfolio is divided approximately equally between long-term and short-term maturities. Investors also should consider the implications of the alternative minimum tax, which will affect an increasing percentage of taxpayers if the tax code is not repealed or modified.

Tactical Style Allocation—A New Form of Market Neutral Strategy

Even though there is little evidence of predictability in stock specific risk, most equity market neutral managers still rely on stock picking as the preferred way to generate abnormal returns. In this article, the authors document the benefits of a new form of market-neutral portfolio strategy that aims at delivering absolute return over the full business cycle through systematic equity style timing decisions. Using a robust multi-factor recursive modeling approach, they find strong evidence of predictability in value and size style differentials. They use these econometric forecasts to generate systematic style timing allocation decisions. These portfolio decisions can be implemented using Exchange Traded Funds on US style indexes.

The Performance of Global Portfolio Recommendations

In this paper, we report the first empirical tests concerning the performance of international investment strategies recommended by a panel of investment houses from 1982 through 2001. The data for this study comes from surveys published in the Financial Report, a confidential newsletter purchased by The Economist Newspaper, Ltd., in 1989. In the surveys, the investment houses recommended strategic asset allocations among equity, bonds, and cash, as well as tactical equity allocations across six countries. The performance of the recommended portfolio weights are compared to several pre-specified static benchmark portfolios. We also compare the returns of the recommended portfolio weights to a set of 1,000 returns that are generated by randomly shuffling the recommended weights. As a final measurement, we test whether the investment houses had superior information after adjusting for a set of conditioning variables. In this sample, it appears that the investment houses had little skill at recommending tactical equity allocations across countries. However, it does appear that the investment houses, as a group, had some skill concerning strategic asset allocations. We find that the market crash of October 1987 may have had a profound effect on the strategic portfolio performance. Before the Crash, the investment houses, as a group, exhibit skill. That is, they outperform several static and dynamic benchmarks. After the Crash, it appears that the investment houses overweighted in bonds for a lengthly interval, which may have led to inferior performance.

Evidence of Predictability in Hedge Fund Returns and Multi-Style Multi-Class Tactical Style Allocation Decisions

While there has been a significant amount of research on the predictability of traditional asset classes, very little is known about the predictability of returns emanating from alternative vehicles such as hedge funds. This is perhaps surprising, given that significant attempts at structuring the alternative investment markets have occurred over the last decade which now allow investors to implement dynamic trading strategies in hedge fund indexes. This paper attempts to fill this gap by documenting evidence of predictability in hedge fund index returns, focusing on their use for tactical style allocation decisions. Using data from nine CSFB-Tremont hedge fund indexes, we find that there is strong evidence of very significant predictability in hedge fund returns. We also find that the benefits in terms of tactical style allocation portfolios are potentially very large. Even more spectacular results are obtained both for an equity-oriented portfolio mixing traditional and alternative investment vehicles, and for a fixed-income oriented portfolio mixing traditional and alternative investment vehicles. These results do not seem to be significantly affected by the presence of reasonably high transaction costs.