How should investors measure the value of tactical deviations from a strategic asset class allocation? In their December 2012 draft paper entitled “A Framework for Examining Asset Allocation Alpha”, Jason Hsu and Omid Shakernia decompose sources of alpha for a diversified portfolio. Their decomposition assumes prior determination of the strategic asset allocation (policy portfolio), consisting of indexes that proxy for broad asset classes. They define tactical asset allocation (tactical portfolio), also consisting of indexes, as deviation from the strategic allocation. They define manager selection (implemented portfolio) as the set of tradable assets used to implement the tactical allocation. Total alpha is the return of the implemented portfolio in excess of that for the policy portfolio, a combination of excess returns from tactical allocation and manager selection. The excess return of the tactical portfolio over the policy portfolio is the asset allocation alpha, the focus of the paper. Based on prior research, they conclude that:
Sources of asset allocation alpha include deviation from the policy portfolio to exploit:
- The power of economic indicators (such as GDP growth, credit conditions, inflation, central bank policy and geopolitical stability) to predict asset class index returns.
- Relative value differences among comparable indexes by constructing and maintaining a tactical portfolio that mimics overall policy portfolio risk exposure with relatively cheap assets (indexes).
- Predictable time-variation in asset class risk premiums across the business cycle, while maintaining an average risk exposure similar to that of the policy portfolio.
In summary, outperformance of a tactical asset class allocation relative to a strategic asset class allocation has macroeconomic, relative valuation and business cycle components.
The paper provides examples of the different sources of asset allocation alpha.
Cautions regarding conclusions include:
- The paper does not address determination of a strategic asset allocation (policy portfolio), treating this decision as a given.
- It is not obvious that the first and third specified components of asset allocation alpha are distinct.
- The paper does not mention deviations from the policy portfolio based on technical indicators (for example, momentum strategies designed to exploit asset class return autocorrelation).
- Measuring strategic asset allocation and tactical asset allocation performances based on index returns has the advantage of setting an aggressive benchmark for actual performance, but the disadvantage of encouraging unreasonably high expectations. The costs of transforming indexes into tradable assets, with attendant management fees and trading frictions, are unavoidable.
