Why Investors are turning to tactical asset allocation for diversification benefits

In the years following the Global Financial Crisis, the Federal Reserve’s (“Fed”) zero interest rate policy and quantitative easing program successfully increased asset prices and depressed market volatility. Ultra-low interest rates and unprecedented liquidity often times fueled speculation in the U.S. equity market by extrapolating future profits and stretching valuations beyond any reasonable earnings power. This investment environment distorted normal price discovery that active managers and asset allocators have historically relied on. The mantra for investors became “TINA” – there is no alternative to stocks – as investors avoided low risk securities, like Treasuries, and diversification generally, given that U.S. stocks primarily benefited from an environment that fueled the dominance (and concentration) of U.S. companies. Active asset allocation can be challenging in these types of periods.

Generationally high rates of inflation initiated an aggressive monetary policy tightening response through a rapid increase in interest rates and balance sheet reduction. Quantitative easing was designed to increase asset prices, therefore quantitative tightening will likely continue to pressure asset prices – reversing loose financial conditions by squeezing liquidity. The normalization process should bring back more traditional market forces and the price discovery needed for a more efficient allocation of capital. This means rewarding winners and punishing losers appropriately. The resulting higher levels of market volatility create greater dispersion among asset classes, which should favor active allocation strategies.

Investors are now rethinking the “TINA” strategy, as opportunities become more fragmented and harder to find. The “TINA” mantra has transitioned to “TARA” – there are reasonable alternatives, or “TAPAS” – there are plenty of alternatives to stocks. Transitioning away from “TINA” should lay more fertile ground for diversification. We expect lower positive, or negative correlations, to be re-established; higher interest rates on fixed income; and shifting global economic fundamentals for greater geographic opportunities. This means more opportunity for active allocation selection – a nimbler approach to portfolio management – one that can now more effectively include bonds, international and emerging market equities, and other opportunistic allocations to sectors or industries that would further diversify investors’ portfolio allocation. No longer is the assumption that U.S. equities are investors best or only opportunity. Investors can maximize diversification with an active, tactical asset allocation portfolio.

Active tactical asset allocation involves making both short and intermediate term decisions relative to a strategic asset allocation based on current market conditions and economic trends. In contrast, a static buy and hold allocation involves simply following a predetermined strategic asset allocation, regardless of current market conditions. We believe the market environment today presents a great opportunity to utilize an active approach to asset allocation. However, there are pros and cons to actively managing your tactical allocation strategy.

Some of the pros include:

1. Potential for higher returns: Active tactical asset allocation allows for the flexibility to shift asset allocation based on changing market conditions, potentially leading to higher returns compared to a static passive allocation.
2. Risk management: Active tactical asset allocation can also be used to manage risk, by adjusting the portfolio allocation to mitigate downside risk during market downturns.
3. Flexibility: These strategies can be tailored to your individual needs and tolerance for risk, rather than a one size fits all static allocation.

However, there are also cons to active tactical asset allocation strategies. At Montag & Caldwell, we attempt to mitigate these risks by combining the best of both active and passive investment approaches.

1. Higher costs: Active management requires more frequent trading and monitoring, which can lead to higher fees and transaction costs. To help offset this risk, emphasize cost-effective strategies. Montag & Caldwell seeks to lower costs associated with active management by employing cost-effective strategies utilizing low-cost ETFs and index funds to implement the tactical allocation strategy, rather than active mutual funds. This helps reduce transaction costs and management fees.
2. Higher risk: Active management can also lead to higher risk due to the potential for market timing errors or incorrect asset allocation decisions. Montag & Caldwell implements risk management tools within its investment process to limit downside risk in case of market downturns. This helps reduce the higher risk associated with active management. To avoid market timing errors and incorrect asset allocation decisions, Montag & Caldwell conducts thorough market analysis before making any investment decisions. This includes analyzing market trends, economic indicators, and global events to make informed investment decisions.
3. Behavioral biases: Active management may also be susceptible to behavioral biases, such as overconfidence or herd mentality, which can lead to poor investment decisions. To avoid behavioral biases, Montag & Caldwell maintains a rigorous and time-tested investment discipline and avoids making impulsive decisions based on emotions or market sentiment. This includes adhering to our predetermined investment plan and avoiding herd mentality. Montag & Caldwell regularly monitors the performance of our tactical allocations and adjusts our investment positions accordingly. This includes analyzing the performance of individual assets, as well as the overall portfolio performance, to ensure that the strategy remains effective and aligned with investment objectives.

Global Tactical Allocation Model

Montag & Caldwell’s Global Tactical Allocation Model (“GTAM”) investment team constructs Client portfolios using a hybrid approach of a top down macro view that emphasizes business cycle dynamics, coupled with fundamental and qualitative insights from decades of managed money experience.  The team begins with a strategic allocation model that incorporates long-term capital market assumptions for different asset classes, sectors and geographies.  This allocation is designed to represent a portfolio that compensates the investor for systematic market risks (risks that can’t be diversified away).  The strategic allocation is represented by the strategy’s benchmark.

The Investment Committee will then make both short and intermediate term tactical adjustments relative to the strategic allocation to capitalize on market opportunities, or to avoid near-term risks.  The team monitors a variety of macro-economic data points to assess where we are in the business cycle; we incorporate changes in monetary policy to our assumptions; and a variety of valuation metrics and growth assumptions; as well as technical and sentiment indicators.  By managing the portfolio’s active risk, we believe we can achieve stronger risk adjusted relative performance.