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© Copyright 2000 Rogers Media. The following article first appeared in the May 2000 edition of
BENEFITS CANADA magazine.
The arrival of TAA overlay
Tactical asset allocation overlay consistently adds value to pension investments while minimizing
risk. With more than $4 billion of TAA overlay mandates assigned in Canada over the past three years, it's
not surprising this strategy is gaining ground.
By Maxime-Jean Gérin
The growing popularity of the specialist manager has lead to a much broader and better array of investment
products for each of the asset classes in a typical pension fund.
However, it has also raised legitimate questions regarding one of the most important investment
responsibilities: Who manages the asset allocation? Are the trustees properly qualified and prepared to
protect the portfolio against a prolonged market decline?
Fortunately, the trend to specialist management has spurred the development of expertise in asset
allocation not previously available to the average balanced pension fund.
Tactical asset allocation (TAA) has traditionally entailed shifting moneys invested in one asset class to
another, to take advantage of short- to mid-term market opportunities and protect the fund against losses.
When a portfolio is entrusted to a single balanced manager, this process is relatively seamless. But in
situations where a number of specialist managers share the assets of a portfolio, the costs associated with
the requisite transactions, the interruption of the management process and the reallocation of funds
between managers have proven prohibitive.
TAA overlay resolves these problems. It provides a means of modifying the asset mix through the use of
derivative instruments to enhance the return of the fund, without interfering with the work of specialist
asset class managers. The fund's assets remain fully invested with specialist managers, while the TAA
overlay manager modifies the effective weight of asset classes by taking positions in equity, bond and
currency futures as well as forwards and options--the common tools of management.
ADDING VALUE
The potential value-added component of TAA strategies is based on the opportunities offered by the markets,
and on the ability of specialist TAA managers to take advantage of them.
Over the course of the past 10 years, the average return difference between the best and worst performing
asset class has averaged 52% per year. This is despite the globalization of capital markets (see "Asset
class performance," below).
This market volatility presents active TAA managers with ample, ongoing opportunity to substantially
enhance the return on an investment portfolio and guard against market declines.
To put this into perspective, a relatively small move of, say 2%, in an asset class that is outperforming
another by the 52% margin cited above would enhance portfolio returns by a full percentage point--an impact
on the total fund similar in magnitude to that of a specialist equity manager.
Over the years, numerous studies have concluded that there is no evidence that balanced managers add value
through asset allocation.
This is not surprising, given that a majority of the balanced fund managers surveyed have traditionally
preferred to focus on security selection, letting the asset mix drift with the markets around the long-term
asset allocation and then rebalancing annually.
In contrast, firms that have built dedicated teams to manage TAA products have consistently added value
over time. And since the use of derivative instruments requires sophisticated risk management techniques,
TAA managers have contributed significantly to the introduction of risk management in asset allocation, a
key consideration that may have been overlooked by traditional balanced managers.
TWO APPROACHES
There are two main approaches to managing TAA overlays: the model-driven and the judgmental approach.
The model-driven approach relies on computer models, which encompass a large number of relationships that
produce buy and sell orders on various capital markets. The benefits of this approach are the ability of
the model to transact whenever a given set of conditions arises, and the removal of the human factor when
facing uncertain markets.
However, the models are frequently referred to as black boxes because it is often difficult to gain an
intuitive understanding of the strategy, given the complex interactions between the models.
Models also usually limit their investment scope to the G-7 countries due to the enormous amount of data
required and the complexity of building them. Also, models rely on the hypothesis that historical
relationships will continue to determine the future behaviour of capital markets. They lack the ability to
factor in non-quantifiable developments such as increases in geopolitical tensions.
On the other hand, the judgmental approach is conducted by professional asset managers who combine research
with their own judgment in assessing the relative attractiveness of asset classes to devise a strategy. The
advantages of this approach include the ability to identify and anticipate changes earlier than when using
models, and to include non-quantifiable variables. But clients must be confident that managers will have
the requisite skills to interpret the extensive amount of information, as well as the conviction to buy or
sell when appropriate.
MORE CHOICE
With traditional asset allocation, most Canadian funds have a choice among only five asset classes: cash,
bonds and Canadian, U.S. and international equities. Since international equities are usually invested
through pooled funds, this basket of 20 countries and their currencies is difficult to forecast and
expensive to trade.
But with the use of derivative instruments, the TAA overlay strategy expands the universe of investment
opportunities by opening up the basket of international equities so that the TAA manager can examine the
components and pick and choose among them.
In this sense, global TAA overlay mandates specify tactical allocations between regions and countries. And
since the movement of exchange rates is not correlated with the return of equity and bond markets, the
currency allocation is determined independently from the country strategy.
This strategy means that investment risks are better diversified. For example, when circumstances warrant,
the TAA strategy could underweight cash to overweight domestic equities.
Managers might also underweight the expensive U.S. stock market to invest in the rapidly growing markets of
Finland, Sweden and France, instead of the basket of 20 countries of an international equity pooled fund.
And because equity futures do not create an equivalent currency exposure, the TAA overlay strategy is not
exposed to the weak euro, and the Japanese yen could be underweighted to increase exposure to the British
pound.
Opening up the basket of international equities, revealing its contents, and the inclusion of a TAA
overlay, results in even greater benefits at the total fund level. In terms of risk and return, it
significantly improves the ratio of risk required to maximize return. (see "Minimizing risk, maximizing
return," left).
Country decisions can be further refined by using the increasing variety of derivative products now
available, such as those for the NASDAQ, the Dow Jones and sector indexes, to better capture the theme of
the investment strategy. This diversification of strategies enables the TAA overlay to better diversify the
risk by taking a larger number of smaller positions. The result over time is more stable value added.
GROWING SEGMENT
A move by pension fund fiduciaries to rebalance the asset allocation toward the long-term allocation
amounts to a conscious decision to remain indexed. Recent refinements to global TAA overlay services
highlight the potential for institutional investors to enhance their fund's returns and better diversify
the sources of value added.
The substantial and persistent differences between returns on the various asset classes over the years, as
emphasized by the Asia crisis of 1997 and 1998, confirms that global TAA should be an integral part of any
prudently managed portfolio.
With more than $4 billion of TAA overlay mandates assigned in Canada alone over the past three years, this
strategy has been well developed by investment managers, thoroughly studied by pension clients, analysed by
consultants and audited by fiduciaries.
It's not surprising then that, today, TAA overlay mandates represent one of the most rapidly growing
segments of the pension fund management industry.
Maxime-Jean Gérin is first vice-president and chairman of the global asset allocation group at TAL
Global Asset Management Inc. in Montreal.
*** ***
Asset class performance
Despite the globalization of capital markets, the average difference on return between the best and worst
performing asset class has averaged 52% per year over the past 10 years.
*** ***
Minimizing risk, maximizing return
A typical portfolio can achieve greater returns by using a TAA overlay strategy that opens up the basket of
international equities than by simply maintaining international equities as one class. At the same time,
risk is well managed.
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