Tactical Asset Allocation: A Dynamic Investment Strategy

Tactical asset allocation is considered a dynamic investment strategy. In this episode we explore this approach and the certain situations in the marketplace that lead investors to utilize this. Stéphane Renevier, Analyst at Finimize, joins Cassidy Clement to discuss.

Summary – Cents of Security Podcasts Ep. 94

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers, and today I’m your host for the podcast. Our guest is Stéphane Renier, analyst at Finimize. Tactical asset allocation is considered a dynamic investment strategy. In this episode, we explore the approach and the certain situations in the marketplace that lead investors to utilize it. Welcome to the program, Stéphane. 

Stéphane Renevier 

Hi, Cassidy, great to be here. Thanks for having me. 

Cassidy Clement 

Of course. So since this is your first episode, why don’t you tell the listeners a little bit about your background in the industry? 

Stéphane Renevier 

Yeah, sure. So I started as a multi-asset investment analyst at British fund manager Schroders. I was there really involved in managing a risk parity fund. That’s like a kind of all-weather portfolio, if you will, that really aims to perform well whatever the economy throws at it. So, we were investing across stocks, bonds, commodities, and some long-short strategies. I was also pretty involved in the alternative risk premier fund. It’s a bit like a hedge fund’s low-cost cousin. We were really tapping into strategies that aim to profit from behavioral biases like value, momentum, carry—across all of the different asset classes. 
And the goal was to generate returns that didn’t depend on stocks and bonds performing well. And of course, I was also helping manage the global tactical asset allocation fund. So here, as I guess we will go into a lot more detail, the goal was really to come up with uncorrelated sources of return—so, long-short trades. 
Then I was hired by Wells Fargo as a PM and researcher to build an alternative risk premium fund from scratch. It was pretty cool, very fun, but very intense. We had to build like 11 systematic trading strategies in the first year—across all of the different asset classes: fixed income, commodities, FX, and of course, equities. 
I was also involved in managing their tactical asset allocation fund. Then the pandemic happened. Big changes. I needed a big change. I left the UK, started traveling, and started my own financial education company, Investing New Academy. And then that led me to also join Finimize as an analyst. 
That’s my current role here. Basically, I’m trying to help retail investors make sense of this macro madness that we’re seeing these days. So, I write insights on what’s going on, but also longer research pieces on investment strategies, model portfolios, and investment ideas generally. 

Cassidy Clement 

Well, you sound like the perfect person to ask these questions to today, because you mentioned tactical asset allocation a lot in your background. So when we’re talking about this, most people will think, okay, well it sounds like it’s something that’s rather active or dynamic to how you’re putting in the research and the actual application of your asset allocation. 
So to just jump in, what exactly is tactical asset allocation? And is this something that is more involved than a usual asset allocation, or is it something that kind of sounds fancy, but really there’s a simple way to look at it? 

Stéphane Renevier 

Yeah, sure. So I think TAA, like tactical asset allocation, is really a dynamic investment strategy where basically you’re making short-term adjustments to your portfolio to take advantage of market opportunities. At its core, it’s really built on a very simple belief: that market conditions change, and sometimes there’s an opportunity to improve returns or reduce risk by making temporary shifts in your long-term portfolio. 
So, maybe today you think that stocks look too expensive, and maybe you think that actually bonds seem to offer decent risk-adjusted returns with yields around 4%. And maybe your long-term portfolio is split equally between stocks and bonds. 
But tactical asset allocation in that case would be: look, because I prefer bonds over stocks, I will temporarily deviate from my 50/50 allocation and allocate maybe a bit more to bonds. So maybe I will have like 60% allocated to bonds and 40% allocated to stocks. 

It’s really this idea of profiting from medium-term opportunities. And by the way, it’s not just between stocks and bonds. It could be across different asset classes or even sectors or even a region. 
But typically, when we say tactical asset allocation, it’s typically done at a top-down level, right? Meaning that investors would typically look at broad asset class shifts rather than picking individual stocks. 
And the goal, again, of tactical asset allocation is really to do a bit better than a purely passive, fixed asset allocation. So that could mean either through achieving higher returns or also through achieving lower risks and avoiding big losses. 
Tactical asset allocation, at the end of the day, is just basically about being really proactive—and not just sitting back and watching your long-term portfolio without doing anything—but really being proactive and adapting to the market environment. 

Cassidy Clement 

You had mentioned medium-term or short-term goals with this as opposed to, as you just said, the sit back, relax, and wait for the long-term years to go by. When we’re looking at tactical asset allocation, how is that differentiating itself from strategic asset allocation? 
From a thousand feet or the 10,000-foot view, you would go, okay, well strategic seems to be a little bit more of a long-term view, where tactical is something short-term—a lot more active—because you’re dynamically changing this portfolio or this fund from the perspective of what’s happening today or what’s happening in the next financial quarter. What are the other key differences between the two: tactical and strategic? 

Stéphane Renevier 

Yeah, sure. So, I’ll try to give you an analogy to make sense of it. You can imagine that your strategic asset allocation is a bit like when you set your GPS for a long-term trip, right? When you start, it gives you the best route given your objectives, given where you want to go, and given the information it has at the moment. 
So that’s really your strategic asset allocation, right? That’s your long-term mix of assets that will align with your financial goals, your time horizon, your risk tolerance—and that will hopefully get you to where you want to go using the information that you have at the moment. 
But as you’ve probably experienced many times, then you take to the road, and it’s very unlikely that nothing happens and you’ll just reach your destination. And if you do, that’s perfectly fine, right? In that case, your strategic asset allocation gets you to the destination. Everything is perfect. 
But sometimes, unexpected things can happen, right? Maybe there’s a traffic jam. Maybe there’s a storm, a road closure. And if you just stick rigidly to your original itinerary, maybe you’ll be stuck—or maybe it will take much longer to actually reach your objectives. 
So that’s where really tactical asset allocation comes in. It’s about adjusting in real-time to the conditions—rerouting to avoid the roadblocks, to avoid the traffic jams, and reaching your destination much more efficiently. 
Just to give you maybe a simple example to illustrate that.. Maybe you’re very happy with a 60/40 allocation—meaning 60% allocated to stocks and 40% allocated to bonds. It’s a decent starting point. It’s working over the long term. 
So, let’s say you’re very happy with this approach, but then 2022 comes around and there’s this inflation spike, and then you start to see both stocks and bonds struggling at the same time. 
So here, for example, I think it does make sense to consider potentially allocating a little bit of your capital to, let’s say, commodities, right? Just because they historically perform better in inflationary environments. 
Here, you don’t want to own commodities at all times. It’s not part of your strategic asset allocation. You want 60% stocks, you want 40% bonds. But for example, when you start to see that inflation is spiking—that’s a threat to your strategic asset allocation, to your long-term portfolio—then it makes sense to temporarily deviate from that. 
Again, you see the traffic jam, and you avoid it. You temporarily hold some commodities, and once the inflation spike has passed and markets return to normal, you just go back to your original asset allocation. 
So tactical asset allocation really is not about abandoning strategic investing, but it’s really just about adding a layer of adaptability, I would say—really helping your portfolio perform better across different economic environments. 

Cassidy Clement 

You had mentioned in your response there a little bit of an example of looking at the classic 60/40 type of portfolio and then adapting it for, let’s say, inflation. Are there any other examples that you can give for tactical asset allocation that maybe is in response to something like the client has fears for their cash, or maybe an economic recession, or things of that nature? 
Or maybe if their portfolio is something that derives a lot of value out of the yield curve, what are some ways that people can use tactical asset allocation in an example form for their portfolio? 

Stéphane Renevier 

Yeah, sure. So maybe just before we go into that example, I think it’s important to differentiate between two types of tactical asset allocation. 
First, you’ve got discretionary tactical asset allocation. Here, it’s really using your judgment as an investor—your quantitative analysis of a situation—to make those asset allocation decisions. 
So, you might want to look at stock valuations, interest rates, assess your economic outlook. Do you think there will be a recession? Do you think, on the contrary, there will be a strong recovery? And you use that judgment to make an investment recommendation. 
Back to your example—if you are using discretionary tactical asset allocation, and for example, you fear a recession or that the economy will start to perform a bit worse than investors currently expect, then you could implement a relative value trade where you buy defensive consumer staple stocks and you short a broad market index. 
So you’re really betting on the relative outperformance of defensive stocks over the rest of the market. That would be one example of a kind of discretionary TAA investment. 

Then you’ve got systematic tactical asset allocation. Here, instead of relying on your own judgment and your own qualitative analysis, you use rules and objective indicators to make decisions. 
A typical example is—rather than you just saying, “Oh, I expect the economy to soon enter a recession, so I will move into defensive sectors or I will move into bonds”—you’re actually saying, for example: “I will let the price tell me when to move out of stocks.” 

A typical example is using, for example, the 10-month moving average. So you’re like, “Okay, as long as stock prices are above their 10-month moving average, I will still be fully invested in stocks—or maybe 80% stocks, 20% bonds. But whenever they fall below that 10-month moving average, I will switch to bonds—or at least partly switch to bonds.” 
So, I let prices—market prices—or a model or an indicator tell me when to make that decision. And it’s super simple, but it really works. And actually, if you look—on SSRN, the paper that’s been the most downloaded of all the finance papers has actually been a paper published in 2007 by Meb Faber called A Quantitative Approach to Tactical Asset Allocation. And it was literally just explaining that 10-month moving average approach. Super simple—but it really works. So it’s quite impressive. So again: discretionary tactical asset allocation, and then systematic tactical asset allocation. 

Cassidy Clement 

You had mentioned that the look of tactical asset allocation—or we’ll say the viewpoint—is really adapting immediately to current market conditions. You mentioned the 10-month average, using that metric to compare to where you are currently to see what type of dynamic choice you’re going to make. But for some people, they may think, “Well, my investment goals might be a little different. How can I utilize TAA to actually be advantageous to what I need?” Are there certain pros and cons—or maybe some limitations or strengths—that are associated with this type of strategy? 

Stéphane Renevier 

Yeah. So I think an obvious pro really is that asset allocation is the single most important decision you’ll make as an investor. At the end of the day, it will drive most of your returns—probably much more than picking the right stocks. So the pro is that if you get that right, then pretty much everything else will be all right. So it does make sense to spend time looking at tactical asset allocation. 

I think a big pro of tactical asset allocation is really that it helps you navigate different market regimes. And I think particularly in today’s environment, right? We really seem to be—the world seems to be—at a turning point. You’ve got these massive structural shifts happening. Even looking at shorter-term economic indicators, everything seems to be changing. There’s massive uncertainty. And I think in this environment, precisely, it really makes sense to have a strategy that can adapt more quickly, that is more nimble, and that can really adapt to the current investment environment and to the current market conditions. And that also gives you more opportunity to find profitable investments. 

I think if we look over the past 20 years, investing was relatively easy, right? You invested money in a simple tracker fund, you just followed the S&P 500—you would’ve made an absolute killing. Stocks have been doing extremely well. Bonds, up until 2022, have been doing extremely well.You could have been using a completely passive approach and have made a lot of money. 

I think going forward, this will be much more difficult, right? I think there’s a chance that interest rates will remain higher, that inflation will remain higher. Stocks’ valuations are extremely high. So I think the potential returns that you can make through a purely passive approach will probably be much lower than what investors have been able to achieve over the past decade. 
So in that environment, you really need to find another way of getting your extra returns. 

And I think tactical asset allocation in that case is a great way of, one, potentially getting that extra return. And usually, tactical asset allocation strategies do provide you with an uncorrelated source of returns. They tend to be relative views rather than directional views. Also, they really allow you to potentially cut your risk and to really, again, give you that flexibility when things don’t turn out as expected. 

And then I think the biggest drawback or the biggest difficulty is that TAA is tough. And making these calls is extremely difficult, right? There’s no free lunch in finance. There’s no extremely obvious opportunity out there. So, you can get your investment views wrong, you can get your model wrong, and at the end of the day, if you get those tactical asset allocation views wrong, well, they can actually hurt your performance instead of helping it. 

So, it’s difficult. And I think there’s also the fact that the more active you are, of course, the higher your transaction costs—the more it would impact your taxes, etc. So, there are also some other elements that you need to take into account if you want to use tactical asset allocation. 

Cassidy Clement 

I think a lot of people will look at TAA and think, okay, while it has some strengths to it, there’s still the element of market timing risk. There could be some underperformance based on broader economic issues. There can be extreme amounts of complexity, as you mentioned—which is, it’s not just an easy decision. There are so many complexities to consider when you are doing this level of change to your portfolio. 

I think that may lead some people to say, in the simplest of ways, “Why would I want to use TAA in my financial strategy? What would you say to someone who’s asking that level of a question? 

Stéphane Renevier 

Yeah, so I think I would say really two things. The first one is that TAA will really give you that flexibility, but without abandoning your long-term plan, right? So, it’s not about completely changing your portfolio. For example, right now, let’s say you’re a bit worried about the outlook for U.S. stocks. Well, it’s not about cutting your exposure completely to U.S. stocks and never, ever holding U.S. stocks. It’s just dipping your toe and saying, “Okay, I think U.S. stocks are overvalued, so I will reduce temporarily my allocation to them.” And then you go back to your long-term portfolio. 

So I think it’s great because it’s not too extreme. It’s not really market timing in the sense that you are making a huge market call and if you get it wrong, that’s the end of the world. 
It’s really about making small tactical adjustments to that long-term portfolio. 

So, I think TAA really will give you that flexibility without abandoning your long-term plan. 

And then secondly, I would also recommend it to people who want to really learn about investing—learn about global macro investing. Maybe people that, up until now, have been more passive and they want to dip their toes into being a bit more active, but they’re unsure exactly how to do it. 

Well, I think tactical asset allocation is a great way.You won’t be making the big, bold bets that hedge funds would make and taking on a lot of leverage and making these very risky bets. Tactical asset allocation is really, once again, about tilting your portfolio to play your view. It’s not deviating that much from that original portfolio to start with. 

So, I think it’s a great way to basically learn about investing—really, learning by doing. 

Cassidy Clement 

Definitely is something that involves more of an active perspective.If that’s something you’re able to do as an investor, it’s something that you definitely can consider.But you brought up some awesome points today. Stéphane, thanks for joining us. 

Stéphane Renevier 

Cheers. Thank you very much, Cassidy. 

Cassidy Clement 

Sure. So, as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Follow us on your favorite podcast network, and feel free to leave us a rating or review. 

Thanks for listening, everyone.