Fund managers employ a wide range of tactics and strategies to manage a mutual fund’s portfolio and to ensure that it adheres to its investment objectives. One of the many strategies that they use is the tactical asset allocation strategy or TAA. Wondering what it is and how it works? Continue reading to get to know all about this portfolio management strategy that’s routinely used in mutual funds.
What is Tactical Asset Allocation (TAA)?
Tactical asset allocation is an active strategy that fund managers use for allocating assets in a mutual fund. Fund managers who use this strategy often make changes to their mutual fund asset mix to leverage short-term market movements, trends and inefficiencies.
Unlike other mutual fund strategies like strategic asset allocation, which focuses more on the long-term aspects, tactical asset allocation is a more dynamic strategy that requires frequent adjustments to be in tune with how the market moves and how the economic conditions fare in the short term.
Understanding Tactical Asset Allocation
Generally, most mutual funds don’t deviate from their core investment objectives and goals once they’re set. However, funds that use the tactical asset allocation strategy rarely follow such a method. Instead, fund managers constantly monitor market trends and economic developments to search for wealth-creation opportunities.
If any such opportunities present themselves, the managers take steps to modify their asset allocation mix, even if it means temporarily deviating from the fund’s core investment objectives and goals that they initially set.
For instance, if a particular sector is on the rise, a fund manager of a mutual fund with a TAA strategy might go out of their way to invest in it even if it deviates from the fund’s primary objectives. Once the short-term opportunity has been leveraged, the fund manager exits that particular sector and goes back to the baseline asset allocation mix that’s in line with the fund’s goals.
Example of Tactical Asset Allocation
Now that you know what tactical asset allocation is, let’s look at one of the most common tactical asset allocation strategies to understand how the concept works.
Assume you’re a fund manager who uses a tactical asset allocation strategy for your fund. The baseline asset allocation mix of your mutual fund is 60% equity and 40% debt. The sector-wise breakdown of the mutual fund’s equity assets is as follows: 20% Information Technology, 10% FMCG, 50% banking and financial services, and 20% pharmaceutical.
After monitoring the market trends and economic conditions, you conclude that the renewable energy sector has a promising future and that it is likely to do well in the short term. Although the sector is not part of your initial asset allocation mix due to it not being in line with the fund’s goals, you still choose to invest in it due to the attractive investment opportunity it presents.
You decide to reduce your exposure in banking and financial services from 50% to 30% and invest the remaining 20% in the renewable energy sector. As expected, the sector is experiencing a major boom, and your portfolio value is rising. Since you’ve successfully leveraged the short-term opportunity, you decide to revert to your baseline asset allocation mix just before the sector corrects itself.
Importance of Tactical Asset Allocation
Tactical asset allocation has several benefits that make it a very important strategy for many fund managers. Here’s a quick look at some of the reasons that drive home the importance of TAA.
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Potentially higher returns
Tactical asset allocation aims to capitalise on short-term market opportunities, which can potentially lead to higher returns compared to a static portfolio.
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Reduced risk
By adjusting your asset mix to reflect market conditions, tactical asset allocation lets you mitigate downside risk during market downturns.
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Increased portfolio diversification
Tactical asset allocation can help you diversify your portfolio beyond traditional asset classes and potentially find uncorrelated investments.
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Adaptability
Instead of simply weathering market volatility, TAA helps fund managers actively navigate and adapt to changing market conditions. When executed right, the strategy may even lead to higher returns.
Types of Tactical Asset Allocation
Contrary to popular opinion, tactical asset allocation is not a single strategy. There are multiple different types of TAA that fund managers routinely use. Here’s a quick look at three of the most common types.
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Systematic Tactical Asset Allocation
As the name implies, systematic TAA uses data-driven models and quantitative analysis to identify and exploit market inefficiencies and pricing differences. The method uses comprehensive models that can identify temporary imbalances among different assets.
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Discretionary Tactical Asset Allocation
Discretionary TAA, on the other hand, is not data-driven and relies primarily on the fund manager’s experience and judgment. Managers use their intuitive abilities to interpret market conditions and make decisions based on their conclusions.
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Hybrid Tactical Asset Allocation
Hybrid TAA uses a mix of both systematic and discretionary tactics. It uses both quantitative analysis and human experience to identify potential short-term opportunities.
Reasons for Tactical Asset Allocation
There are a plethora of reasons why fund managers use tactical asset allocation strategies to manage their mutual funds. Here’s a brief overview of some of them.
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Ability to Exploit Market Inefficiencies
Although the pricing mechanism in the market is highly efficient, there may be certain inefficiencies that lead to overpriced or underpriced assets. Tactical asset allocation strategies allow fund managers to exploit these short-term inefficiencies to generate returns.
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Cushions Against Downturns
Tactical asset allocation may protect the fund from the effects of bearish market movements. Fund managers could shift over to defensive assets like gold or bonds temporarily till the bearish phase passes.
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Allows Hedging
Macroeconomic factors like interest rates, geopolitical events and inflation can have a strong effect on the performance of many assets. With TAA, fund managers can adjust their asset mix in a way that’s more in line with the changes in these factors.
Tactical Asset Allocation vs. Dynamic Asset Allocation
Both tactical asset allocation and dynamic asset allocation are strategies that mutual fund managers use to manage their funds. While they’re very similar, they do have their fair share of differences. Here’s a table outlining some of the key differences between these two kinds of strategies.
| Particulars | Tactical Asset Allocation (TAA) | Dynamic Asset Allocation (DAA) |
| Type of Strategy | Supplementary mutual fund strategy | Principal mutual fund strategy |
| Objective | Seeks to capitalise on short-term market opportunities and manage risks | Aims to optimise long-term returns and manage risks over market cycles |
| Time Horizon | Short to medium-term focus | Medium to long-term focus |
| Frequency of Adjustments | Can be more frequent, depending on market conditions and strategy | Adjustments are made less frequently, typically in response to significant changes in economic or market conditions |
| Flexibility | Highly flexible, allowing for quick responses to changing market conditions | Flexible, but adjustments are typically made in a more deliberate and strategic manner |
| Risk Management | Focuses on managing short-term risks and adapting to market fluctuations | Emphasises long-term risk management and aligning the portfolio with prevailing economic conditions |
| Role in Diversification | May involve shifting allocations among different asset classes to capture opportunities | Aims to optimise the overall portfolio by adjusting allocations based on the long-term outlook for various asset classes |
Conclusion
Tactical asset allocation gives fund managers the freedom to stray away from the core objectives of their fund temporarily to exploit short-term opportunities. TAA as a strategy is not exclusive to mutual fund managers alone. In fact, as an investor, you can also use tactical asset allocation as part of your investment strategies. However, remember to monitor the markets thoroughly to ensure that you spot short-term opportunities on time.
FAQs
How does TAA vary from Strategic Asset Allocation (SAA)?
Unlike strategic asset allocation, which follows a fixed, long-term allocation plan, tactical asset allocation allows for flexible adjustments in response to changing market conditions.
What factors influence tactical asset allocation decisions?
Market trends, economic indicators, interest rates, geopolitical events and valuation metrics are some of the factors that influence decisions.
Are there any drawbacks to tactical asset allocation?
Yes. Tactical asset allocation involves the risk of incorrect market forecasts, leading to suboptimal investment decisions. Another drawback is frequent trading, which can result in higher transaction costs.
Is tactical asset allocation suitable for long-term investors?
TAA is often considered more suitable for investors with a shorter investment horizon, but long-term investors may also incorporate tactical adjustments to manage short-term risk.
Can tactical asset allocation be combined with other investment strategies?
Yes, investors often combine TAA with other strategies like diversification, buy-and-hold, or systematic rebalancing to create a well-rounded investment approach.
