Making Volatility Work For You Through Tactical Asset Allocation
Point of View With Michael Fredericks
Although markets have recently been buffeted by tremendous volatility, Michael Fredericks believes investors can benefit from tactical asset allocation (TAA), a diversified, performance-enhancing approach to portfolio management.
- TAA becomes particularly important in uncertain or volatile markets when securities tend to become more correlated and traditional methods of strategic diversification do not work.
- TAA strategies are designed to actively reallocate across asset classes to gain exposure to market leaders, to reduce exposure to volatility and potentially increase returns.
- Manager scale, market knowledge and global insight are important to successfully make tactical allocations within multi-asset class portfolios.
Q. What is Tactical Asset Allocation?
As all investors know, deciding how to allocate across various asset classes is frequently the most important decision one needs to make. A good way to understand tactical asset allocation (TAA) is to explain that it is different from a traditional strategic long-term target portfolio of assets typically made in major asset classes such as stocks, bonds and cash based on the investor's objective, time horizon and risk tolerance. TAA is an active management portfolio strategy in which the manager rebalances the percentage of assets committed to certain categories in order to take advantage of pricing inconsistencies or other market signals. It provides a much broader level of flexibility for a manager to allocate among various asset classes, regions and sectors to take advantage of potential opportunities in a given market environment.
Q. What are the benefits of professional tactical asset allocation?
A major advantage of TAA is that it removes the burden of asset allocation from individual investors and places it squarely in the hands of financial professionals and experienced investment managers. If you look back through time at the performance of specific asset classes, you can see how volatile each individual asset class can be on a year-over-year basis. For example, the "core equities" category that measures US large cap stocks was up 5% in 2007, down 38% in 2008 and up 28% in 2009.
While investors fret over the impact of volatility on a traditional portfolio, a TAA manager is able to take a more diversified approach to portfolio management, incorporating a broader set of assets including stocks, bonds, currencies, commodities and alternative investments to control the overall risk of the portfolio and lead to more consistent results. Using a risk-controlled process, the TAA manager is able to actively reallocate portfolios to gain exposure to more attractive asset classes, to reduce exposure to volatility and to potentially increase returns. The enhanced access to information, research and analysis that professional managers have can help them anticipate economic cycles and better allocate multi-asset class portfolios.
Q. When are tactical asset allocation solutions particularly effective?
Because tactical asset allocation can dynamically and actively respond to valuation and economic changes, the strategy can be beneficial in any market environment. As you can see in the chart below, the performance of different asset classes can vary significantly over time. For example, in the current environment, macro developments (e.g., European sovereign debt issues, questions around the global economic recovery and concern over monetary and fiscal policy) have significant effects on markets and securities. Tactical asset allocation allows a skilled manager with global insights to act nimbly in anticipation of global developments and make the appropriate asset and subasset allocation decisions based on that insight.
Individual Asset Classes Can Be Volatile
Annual percent returns of indexes and 'diversified portfolio' benchmark performance
Source: PSN Enterprise. Past performance does not guarantee or indicate future results. The information provided is for illustrative purposes only and is not meant to represent the performance of any particular investment. Investing involves risk. Asset class returns are represented by the returns of indexes and are ranked on an annual total return basis. It is not possible to invest directly in an index. Core Equity is represented by the Russell 1000 Index. International Equity is represented by the MSCI EAFE Index. Small / Mid Cap Equity is represented by Russell 2000 Index. Emerging Markets Equity is represented by the MSCI Emerging Markets Index. Taxable Fixed Income is represented by the Barclays capital aggregate bond index. High Yield Taxable Fixed Income is represented by the Barclays capital high yield corporate bond index. International Bond is represented by the Barclays capital sovereign index. Emerging Markets Bond is represented by the Citigroup global emerging markets sovereign index. TIPS is represented by the Barclays US Inflation Protected Index. Commodity is represented by the S&P Goldman Sachs commodity index. Treasury is represented by the ML US 3-month treasury index. For purposes of this page, the Diversified Portfolio reflects the benchmark allocations for the a hypothetical portfolio and is composed of the following indexes: 29% Russell 3000 Index, 25% MSCI EAFE Index, 4% S&P Goldman Sachs commodities index, 2% Dow Jones real estate index, 35.5% Barclays capital aggregate bond index and 4.5% Citi 3 month t-bills. The Benchmark returns shown reflect rebalancing of the Benchmark's component indexes to their established percentages on January 1 of each year. Past performance is no guarantee of future results. Index performance is for illustrative purposes only. You cannot invest directly in an index.
Q. How does a TAA product fit into an investor's portfolio?
Many investors begin to structure their portfolios by building out an asset allocation that is appropriate for their risk tolerance. They then hire separate managers to oversee their large cap equities, international equities, domestic bonds and so forth. The independent managers do not work together in developing a well-positioned portfolio but concentrate solely within their assigned asset class. Moreover, volatile markets can cause the portfolio's original allocations to shift over time, causing unintended changes to the overall risk profile of the strategy.
What we do is get beyond those sorts of problems by taking an all-inclusive look at an investor's portfolio. In conjunction with an individual's financial professional, a single TAA manager can ensure the entire portfolio is working together to help capitalize on expected market conditions. This also allows the manager to understand and monitor the risk of the entire portfolio and rebalance if this risk shifts outside the investor's tolerance level. As a core holding, a TAA strategy can provide adequate diversification and offer individual investors exposure to asset classes they might not have sufficient capital or expertise to invest in.
Q. How do tactical asset allocation managers add value to portfolios?
There are a couple of ways TAA managers can add value to portfolios. With a professional manager actively guiding allocations, a tactical asset allocation strategy aims to focus on those areas of the market we believe have the most upside opportunity. We also look to avert or side-step bear markets by avoiding or underweighting those asset classes that we believe will lose value. As a result, effective rotation among asset classes has the potential to generate attractive capital appreciation in a highly diversified and riskcontrolled manner (see chart below). At BlackRock, we believe our scale and global insight put us in a strong position to decide how to allocate multi-asset class portfolios.
Tactical asset allocation can benefit a portfolio
Change in value of hypothetical $1 million investment (Dec 31, 2000-Dec 31, 2010)
Source: PSN Enterprise. Past performance does not guarantee or indicate future results. The information shown is for illustrative purposes only and is not meant to represent the actual or potential performance of any particular investment strategy. Asset allocation strategies do not ensure profit and may not protect against loss. The Static Asset Allocation Portfolio consists of 55% Equities and 45% Fixed Income. The hypothetical best case and worst case tactical asset allocation portfolio decisions were made by reviewing historical monthly returns for two different potential asset allocations: 1) 75% Equity & 25% Fixed Income, and 2) 35% Equity & 65% Fixed Income. The best case allocation selected the allocation that generated the highest return in each month. The worst case allocation selected the allocation that produced the lowest return in each month. The monthly returns were linked to generate the hypothetical returns shown above. Equities are represented by 45% Russell 3000 Index, 36% MSCI EAFE Index, 9% MSCI Emerging Markets Index and 9% S&P Goldman Sachs Commodities Index. Fixed Income is represented by 11% Barclays Capital Aggregate Bond Index, 22% Barclays Capital High Yield Corporate Index, 22% Barclays Capital Sovereign Index, 22% Citigroup Global Emerging Markets Sovereign Index and 22% Barclays Capital TIPS Index.
Q. Tell me about the team that manages tactical asset allocation strategies?
BlackRock has assembled a talented team of investment professionals focused on adding value through tactical asset allocation. The BlackRock Multi-Asset Client Solutions (BMACS) team within BlackRock's Portfolio Management Group leverages the firm's insights to develop, assemble and manage investment solutions involving multiple strategies and asset classes. The BMACS team includes over 150 portfolio managers, quantitative analysts, investment strategists, research analysts, economists and actuaries. In addition to managing portfolios for individual investors, the team's clients also include some of the most sophisticated institutional clients in the world, including well known endowments, pension plans, and sovereign wealth funds.
BMACS uses investment products and strategies involving a broad range of equity, fixed income, alternative and derivative investments that reflect the diversity of BlackRock's products. The team actively researches and seeks return-generating strategies from both internal and external managers. Our presence in 24 countries and the intellectual capital across the firm help us effectively allocate among different asset classes and geographies, particularly as we are able to leverage the unique insights of BlackRock's other portfolio management teams across asset classes and geographies.
Q. How does BMACS design and implement a tactical asset allocation strategy?
The first step we take in building a strategy is to design a benchmark that appropriately matches an investor's risk tolerance and investment goals. (see chart below) For example, an investor with a moderate risk tolerance may want to use a benchmark composed of 60% equities and 40% fixed income as the point of reference when BMACS makes its allocation decisions. BMACS then determines advantageous changes to that allocation based on the team's outlook of macroeconomic, country, sector and currency views. The team incorporates both short-term assessments, like relative performance and investment flows, as well as longer-term factors, such as valuation. The BMACS approach to TAA leverages multiple factors and typically results in more reliable performance.
In building their market views, the BMACS team takes advantage of its dedicated internal research team, as well as research by specialized teams across BlackRock. On a daily basis, BMACS leverages the Risk & Quantitative Analysis team to monitor portfolio exposures and risks in order to ensure the portfolio is appropriately aligned with the team's research views. The BMACS team establishes the overall portfolio's asset class weightings, allocates capital among underlying style-specific managers for execution and adjusts allocations as the outlook changes.
BMACS team leverages extensive resources for inputs into investment views
Q. What kinds of risk management practices are employed by BMACS?
Risk management has long been embedded in BlackRock's culture. BMACS works closely with the Risk and Quantitative Analysis (RQA) team which consists of individuals all over the world who do not manage portfolios, but instead focus primarily on analyzing and quantifying portfolio risks. In addition to integrating RQA findings, our risk management processes include daily risk reviews and stress tests, weekly portfolio construction discussions and monthly senior management reviews of performance and risk levels. Furthermore, portfolios are constructed to respond to periods of increased correlation and risk factors (see chart below).
Dynamic Risk Management Lowers Volatility
Expected volatility in normal vs. dynamic risk models
BlackRock. As of 11/15/11. Expected volatility based on proprietary BlackRock risk models.
Q. How do I access TAA strategies that are managed by BMACS?
The BMACS team manages a number of tactical strategies for individual investors that are available at our partner firms including pooled investment funds and separate accounts. Your Financial Professional or BlackRock representative can provide more information regarding these strategies and their suitability for your portfolio.
BlackRock Portfolio Managers respond to key market events in this timely interview series.
About Mr. Fredericks
Michael Fredericks, Managing Director, is head of US Retail Asset Allocation for the BlackRock Multi-Asset Client Solutions (BMACS) group. He is responsible for the development and management of asset allocation strategies for individual investor clients. Mr. Fredericks joined BlackRock in 2011 from JPMorgan Asset Management where he was an Executive Director and portfolio manager in the Global Multi-Asset Group responsible for retail asset allocation solutions.
Asset allocation strategies do not assure profit and do not protect against loss. Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of November 18, 2011, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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