At State Street Global Advisors, we believe global capital markets can be inefficient in the short run ̶ driven by behavioral biases, market frictions, and fluctuations in risk aversion. Incorporating tactical asset allocation (TAA) can be a way to exploit these inefficiencies and provide the potential for an uncorrelated source of excess return, while helping to manage risk.
Generally, the objective of TAA is to outperform the benchmark (strategic asset allocation) by dynamically pulling the levers of asset allocation. Our quantitatively anchored, tactical investment process is refined with qualitative insights from our team of experts and managed in a risk-aware framework.
The Opportunity Set
Our tactical asset allocation investment process seeks to exploit two related but different categories of investment opportunities ̶ directional and relative value. In the directional category, we evaluate broad asset class comparisons, (i.e., global equities vs core bonds), while in the relative value category we examine intra-asset class opportunities, (i.e., country, region or sector within equities and treasuries versus credit within fixed income). We make this nuanced but important distinction to most effectively utilize our quantitative and discretionary resources.
Broad Asset Class Opportunities
Equities, Core Bonds, Commodities, Gold, High Yield, & Cash
Intra-Asset Class Opportunities
Equities: Sector, Country, Region
Source: State Street Global Advisors, Investment Solutions Group (ISG)
The tactical investment process begins with an assessment of the current political and policy environment, risk sentiment and macroeconomic conditions. Next, we use our proprietary models to objectively evaluate and make asset class comparisons. This is followed by a qualitative review to identify potential blind spots in the quantitative models.
When evaluating the broad asset class or directional opportunities, we think it is critical to be mindful of investor attitudes toward risk. Determining the level of risk appetite present in the markets helps us understand investor attitudes towards risk assets. State Street Global Advisors’ Market Regime Indicator (MRI) is a dynamic model that incorporates global credit spreads, equity implied volatility, and currency-implied volatility to evaluate investor risk sentiment and identify investors’ risk aversion levels. The underlying signals are geographically diversified within each asset class. Increasing implied volatility and widening credit spreads suggest heightened risk aversion, both of which can be headwinds for growth assets. Ultimately, a combination of our market regime indicator model, macroeconomic, and policy and politics views help shape our outlook on risk aversion in the market.
Figure 2: The Market Regime Indicator
Our research shows that each market regime can have distinctly different return and drawdown attributes. A low-risk aversion regime is typically the most profitable environment for taking risk. In contrast, in a high-risk aversion regime, growth assets can deliver substantial negative returns. The MRI is a key driver of the active positioning for those broad-based, directional opportunities. During high-risk aversion regimes, we will typically underweight the allocation to equities and favor a risk-hedging basket of US Treasuries, gold and cash. Conversely, during low-risk aversion regimes, we switch the portfolio allocation in favor of global equities and reduce the exposure to core bonds.
In addition to our market regime indicator model, we employ a quantitative framework to evaluate the relative attractiveness of various assets and form total return forecasts. We use these models to help identify both directional and relative value investment opportunities. Our proprietary models employ a multi-factor approach to sift through large quantities of data and evaluate the attractiveness of investment opportunities through a fundamental lens. These include both top-down and bottom-up analysis to forecast predicted returns for over 100 market segments. Top-down macroeconomic factors include variables such as inflation, GDP growth, and leading economic indicators. Bottom up or Asset class specific factors include earnings and dividend yields, valuations, credit spreads, and momentum.
Tactical asset allocation can be an effective way to exploit asset-class level inefficiencies to generate a diversified source of excess return and help manage risk. To learn more about the key factors motivating our current TAA positions, click here.
Investing involves risk including the risk of loss of principal.
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