What is the purpose of this paper?
In a previous paper, we addressed the issue of how to set investment objectives. In this paper, we address another key issue in the definition of asset allocation: how to articulate it across different time horizons. More specifically, we aim to answer the following questions:
- What are the typical definitions of strategic and tactical allocation as well as of medium-term asset allocation as an intermediate layer?
- What are the decision drivers across these different horizons?
- How is investment governance organised at these three levels?
- How does one budget risk across them?
Who is this paper for?
It is directed towards institutional investors and should be particularly relevant for investment professionals involved in setting strategy or exercising management responsibilities within an investment organisation.
Key messages and recommendations:
- Strategic Asset Allocation (SAA) is the key decision for all institutions, as it is representative of their risk appetite and return objectives.
- Mid-term Asset Allocation (MTAA) can be a useful for tilting SAA towards certain strategies expected to outperform in the medium term.
- Those investors that believe in the potential benefit of active management can implement Tactical Asset Allocation (TAA). Investors should then make sure that they provide portfolio diversification.
- SAA, MTAA and TAA have different drivers: long-term returns and risk assumptions for SAA, expectations on the economic and monetary cycle for MTAA, and short-term risk and momentum-based indicators for TAA.
- The leeway allowed to TAA strategies depends on the investor belief, but it should be limited in order to avoid any significant modification of the investor portfolio’s risk profile.
- In quantifying such leeway, the use of risk-based indicators such as Value at Risk (VaR) and Conditional Value at Risk (CVaR) looks appropriate.
This is the second paper in a series looking to challenge some of the key components of an investment policy statement and provide practical recommendations on important asset-allocation-related topics. In our next publications, we intend to address the issue of how to segment asset allocation and define the universe of eligible asset classes.