by Niall O’Sullivan, Chief Investment Officer, Multi Asset Strategies – EMEA, & Robert Surgent, Senior Portfolio Manager, Neuberger Berman
June 2023
We recognize that many readers of our CIO Weekly Perspectives are also investors, grappling with the same challenges we face.
One of those challenges is that, while the core of many investment strategies has a time horizon of years or even decades, there are times when shorter-term themes and catalysts at play in the market can be substantial enough to present meaningful risk or opportunity to the portfolio.
Tactical asset allocation offers one way to participate in those opportunities or offset those risks, which often pull against the prevailing exposures of the strategic asset allocation.
Bedrock
You will have your own investment process. But for many, it starts with building a diversified strategic asset allocation, with exposure to a diverse set of return sources: government bonds, corporate bonds, equities and so on.
These assets generate returns partly due to their links to broader economic growth, but also because investors have frequently failed the test of holding positions for the long term—they are the reward for staying the course through the ups and downs of the economy and market pricing.
Almost all asset classes had negative performance during 2022, but many investors who held on were rewarded with positive performance so far in 2023. And over the long term, the premia built into these asset classes to compensate for risk have generally delivered strong returns. That’s the bedrock of strategic asset allocation, and it has worked for most investors.
Variations
You may try to enhance these long-term returns by identifying times when estimated returns have become very different to those you assumed when building your strategic asset allocation, due to valuations or the medium-term economic outlook, and then adopting positioning that differs, sometimes significantly, from the strategic asset allocation.
For example, readers of our quarterly Asset Allocation Committee Outlook will know that we have been cautious in our views since the second half of 2021, when we thought that inflation pressures were rising, interest rates faced substantial upside risk and equity market valuations were too high. Those views would imply positioning that is lower in equities and higher in cash than a long-term strategic asset allocation, and investors positioned this way were rewarded during the stock and bond market selloffs in 2020.
We have persisted with our cautious view on equities so far in 2023, because we anticipate a slowdown in corporate earnings over the medium term and because investors are currently being paid to be patient with high short-dated interest rates.
Views and allocation adjustments like these introduce some timeframe diversification into an investment program, but they are still essentially variations on the strategic asset allocation, not something different altogether. They tend to look at a medium-term, 12- to 18-month horizon and their performance should not be judged over a shorter period than that.
Active management at the underlying asset class level can be another source of additional returns; but again, the timeframes here are typically longer-term, particularly in many active equity strategies. This is why, for example, in times of extreme index concentration like today, active equity managers—for investment and sometimes regulatory reasons—can find it hard to own concentrated positions in individual stocks.
Pitfalls
Indeed, a period like the first half of 2023 highlights the pitfalls of relying solely on these medium-term and strategic views.
Have investors really been paid to be patient? In a sense, yes.
Cash and short-dated Treasuries have been paying around 5% while the equal-weighted S&P 500 Index is roughly flat so far this year. The actual, market capitalization-weighted S&P 500 Index, however, is up 12% this year and has been rallying since last October, and with renewed vigor since March 10.
We’ve written a lot about why this has happened. There has been a liquidity-and-flows element to it: short-covering, buying last year’s losers, momentum trading. There has been a valuation element to it: the sharp downward adjustment in interest-rate expectations in March generated a tailwind behind the mega-cap growth stocks that still dominates the index. And there has been a fundamental element: the initial excitement around advances in artificial intelligence is being priced into a handful of the same mega-cap growth stocks.
Based on the facts as we see them at the moment, do we think the S&P 500 Index can sustain these levels over the next 12 months? Perhaps, but we remain fundamentally cautious—if anything, this upward trajectory makes us even more cautious over the medium- and long-term timeframes that inform our strategic asset allocation.
But do we think the index could continue to confound our fundamental expectations over the next few weeks and months, especially as the AI enthusiasm builds and the worries about the U.S. debt ceiling are put behind us? Absolutely.
This is where tactical asset allocation comes in.
Themes and Catalysts
As the example above suggests, shorter-term market themes and catalysts frequently cut against the exposures that investors are likely to have in their strategic asset allocation.
That’s what makes them annoying—they can temporarily disrupt performance. But it’s also what makes them exploitable; investing in a tactical asset allocation solution can enable an investor to position for them without doubling up the exposures that are already in the strategic portfolio. These solutions can be implemented directly via a derivative overlay inside a portfolio or through an allocation to tactical funds.
A theme like the concentration of AI euphoria in a handful of tech stocks, supporting wider market valuations, might last as long as a year. A catalyst such as sudden changes in portfolio flows or liquidity conditions, or a news event, may create market dislocations or arbitrage opportunities that last a few days or a few months. Either has the potential to add timeframe diversification against the long-term positioning of the strategic asset allocation.
Take Comfort From the Tactical Portfolio—and Profits
Therefore, right now, tactical asset allocators might be looking at the potential for a further bounce in the S&P 500, driven by those growthy mega-caps and perhaps reinforced by one or two stray economic data releases. They might be looking at implied volatility at three-year lows and thinking that those modest premia justify buying some out-of-the-money index call options.
Should they pay off, the strategic asset allocators will be scratching their heads and wondering when the market will finally come back to its senses. But that’s exactly the point of diversifying across timeframes as well as across the traditional vectors of asset class, sector and region. Should it pay off, they can take profits as well as comfort from the tactical portfolio and recycle them into positions that harvest long-term risk premia—which are now likely to be even wider than they were before the latest bout of short-term market dynamics.
