Long-Term Tactical Asset Allocation

Abstract:     
This paper evaluates a long-term tactical asset allocation strategy that takes advantages of perceived short-term opportunities in the capital market while benchmarked against the long-term strategic portfolio. The portfolio strategy makes the portfolio weights depend directly on changes in state variables, and uses an expanded asset menu in the Markowitz framework. The optimal portfolio consists of a benchmark portfolio that controls the active risk, and a pure overlay portfolio that adds active return to the whole portfolio. The empirical analysis shows that the information ratio of the optimal portfolio under the single-period strategy is 0.85. However, an investor may want to constrain the active portfolio strategy such that the tactical asset allocation's risk profile is matched with the strategic asset allocation in the long term. The certainty equivalent to a mean-variance investor with risk aversion of 10 is less than 10 basis points under the unconstrained portfolio strategy and 1.3% under the constrained portfolio strategy, both relative to passive benchmark indexing strategy. Hence, the investor is better off with the constrained active portfolio management.

Keywords: tactical asset allocation, strategic asset allocation, information ratio

JEL Classification: G11, G12

working papers series