Tactical Asset Allocation: From Simple to Advanced Strategies

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Tactical Asset Allocation (TAA) is an active investment strategy that involves adjusting the allocation of assets in a portfolio to take advantage of short- to medium-term market opportunities. Unlike strategic asset allocation, which focuses on long-term asset allocation based on a fixed mix, TAA seeks to exploit market inefficiencies by overweighting or underweighting certain asset classes depending on market conditions, economic outlooks, or valuation anomalies. This approach allows investors to be more flexible and responsive to changing market environments, potentially improving returns while managing risk.

Reference [1] examines five approaches to tactical asset allocation. They are,

1. The SMA 200-day strategy, which uses the price of an asset relative to its 200-day moving average.
2. The SMA Plus strategy, which builds on the SMA 200-day by adding a volatility signal to the trend signal, dynamically adjusting allocations between risky assets and cash.
3. The Dynamic Tactical Asset Allocation (DTAA) strategy, which applies the same trend and volatility signals as SMA Plus but across the entire portfolio, rather than on individual assets.
4. The Risk Parity method, popularized by Ray Dalio’s All Weather Portfolio, equalizes the risk contributions of different asset classes.
5. The Maximum Diversification method, which aims to maximize the diversification ratio by balancing individual asset volatilities against overall portfolio volatility.

The author pointed out,

In conclusion, our analysis of the five strategies—SMA, SMA Plus, DTAA, Risk Parity, and Maximum Diversification—highlights their unique strengths and limits. The SMA strategy, with its binary nature, excels in delivering the best risk-adjusted returns by effectively shifting to cash during downturns, though it may miss early recovery opportunities. The SMA Plus strategy builds on this by adding more dynamism and a less rigid approach, which allows it to achieve higher returns. However, this approach comes with slightly higher risk, as it uses more nuanced allocation decisions. The DTAA strategy, while achieving the highest returns, suffers from significant drawdowns due to its aggressive equity allocation and less effective risk management. In contrast, the Risk Parity and Maximum Diversification strategies emphasize stability, offering lower returns but minimal volatility, making them suitable for risk-averse investors. Overall, the study underscores the importance of selecting a strategy that aligns with specific investment goals and suggests that refining volatility signals and integrating additional asset classes for better diversification could enhance these strategies’ effectiveness in various market conditions.

In short, TAA based on a simple moving average still delivers the best risk-adjusted return.

This is an interesting and surprising result. Does this prove once again that simpler is better? Let us know what you think in the comments below or in the discussion forum.

References

[1] Mohamed Aziz Zardi, Quantitative Methods of Dynamic Tactical Asset Allocation, HEC – Faculty of Business and Economics, University of Lausanne, 2024

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