Tactical Asset Allocation Portfolios

Tactical asset allocation portfolios might sound complicated, but they’re really not. If you have any amount of investable dollars, you should consider allocating a portion to a Tactical Asset Allocation Portfolio. Let’s explore how simple it is to invest in TAA portfolios and why you should start right away.

You might have heard of tactical asset allocation portfolios or strategic asset allocation portfolios. Both sound complex, but that’s just industry jargon designed to intimidate you into avoiding questions, allowing financial professionals to push questionable products your way. In reality, the concept is much simpler, and we aim to educate you on how to invest using TAA portfolios.

Tactical Asset Allocation and Strategic Asset Allocation Definition

Let’s start with a simple definition. Strategic asset allocation portfolios are what most people know as the classic “60/40 portfolio” – 60% in stocks and 40% in bonds. If you have had investable funds in your bank account, you have likely encountered someone calling to offer investment products. Unfortunately, these are often subpar offerings pushed due to commission incentives. This is where tactical asset allocation portfolios come in.

TAA portfolios have existed for years, traditionally available through hedge funds that charged 2% maintenance and 20% performance fees. Today, these investment approaches are accessible to everyone. We have a significant portion of our investable dollars in tactical asset allocation portfolios, and we will share our favorite tool for TAA investing, but first, let’s examine the three primary reasons you should consider TAA.

Systematic Approach

If you’ve been in financial markets for any length of time, you’ve likely experienced a friend, relative, or colleague boasting about their investment performance, usually at a time when your own portfolio isn’t performing as well. You don’t want to be in a position where you’re following someone else’s investment advice, news headlines, or panicking during market drawdowns. A systematic approach provides consistency and discipline.

Dynamic Allocation to Top-Performing Sectors

You want to dynamically allocate funds to the best-performing sectors. Even the best strategic asset allocation portfolios, like Ray Dalio’s “All Weather Portfolio”, while outperforming the S&P 500 over the long term with better key performance metrics in drawdown and compound annual growth rate, remain static, limiting annual performance. While better than simply investing in the S&P 500, static portfolios typically underperform most TAA portfolios.

Superior Performance

Perhaps most importantly, no matter what asset class you select, there will inevitably be periods of stagnation. Consider the S&P 500 from 2000 to 2012, essentially a lost decade with no meaningful gains. Look also at the Japanese stock index, which has seen minimal movement for the past 40 years, or gold from the 1980s until 2008, which showed little progress. If your investments are concentrated in underperforming assets during these periods, your money effectively loses value due to inflation. Performance is the most critical reason to invest in tactical asset allocation portfolios.

How to Invest in Tactical Asset Allocation Portfolios

Now that we understand tactical asset allocation portfolios are superior to strategic asset allocation, how do we invest in them? Rather than following just one TAA portfolio (there are many options), we recommend using tools that simplify the process. If you search academic databases like SSRN for asset allocation papers, you’ll find thousands of results – far too many to review individually.

That’s where Allocate Smartly comes in – an excellent online service focused on tactical asset allocation portfolio research. They offer a free tier providing access to three strategies and a sample model portfolio, giving you a taste of their service before committing to a subscription.

Allocate Smartly features over 60 strategies collected from academic sources like SSRN. These aren’t their proprietary strategies but implementations of peer-reviewed white papers with clearly stated rules. They build models using their data while accounting for variables like timing, commissions, slippage, and more. A notable advantage is their use of highly liquid ETFs to implement these strategies.

Advanced Portfolio Analysis and Optimization

Correlation Analysis Tools

When building a diversified investment approach, you should understand correlations between strategies. We have selected the top eight strategies and examined the correlation matrix between these strategies and the entire database.

Another powerful way to visualize correlations is through cluster analysis, a feature we particularly appreciate. This tool illustrates how strategy categories relate to one another. For example, “Conventional Tactical” strategies will be less correlated with “Primarily Passive” or “RPV GTT and Bonds” approaches. Within these clusters, “Fast Tactical” strategies show lower correlation with “Slow Tactical” approaches. This provides an invaluable top-down perspective on strategy relationships.

Risk vs. Return Visualization

The platform offers intuitive risk versus return scatter plots that map annualized returns against volatility (standard deviation). For instance, the Accelerated Dual Momentum strategy delivers an impressive 16% annualized return but comes with 14% standard deviation. At the other end of the spectrum, you’ll find options like the USRP Trend Following strategy with a 6.3% annualized return and just 5.2% annual volatility.

This visualization makes it easy to identify alternatives to traditional investments. Instead of investing directly in the S&P 500 (which typically yields around 7% annually with significant volatility), you might consider the Permanent Portfolio, which offers 7.2% returns with only 6.5% annual volatility – approximately half that of the S&P 500.

ETF Alternative Options

As previously mentioned, the platform implements strategies using the most liquid ETFs, even when the original strategy specifies mutual funds or indexes. This approach ensures scalability for investors of all sizes. Additionally, they provide alternative ETF options for each asset class, though not an exhaustive list.

For instance, if you prefer not to trade SPY for U.S. large-cap exposure, you might consider IVV, VOO, or SCHX. The platform organizes alternatives by asset classes including:

• U.S. stocks and real estate
• U.S. bonds
• International stocks and real estate
• International bonds
• Gold and commodities

Strategy Asset Matrix

The All Weather Portfolio, for example, trades long-term U.S. Treasuries, U.S. large-cap equities, intermediate U.S. Treasuries, gold, and commodities.

While most strategies on the platform (except for two or three) have open and publicly available rules that you could theoretically implement yourself, the true value emerges when constructing a portfolio of portfolios – known in the industry as a “fund of funds.” Rather than trading a single diversified portfolio, this approach involves trading multiple portfolios with unique characteristics.

Build a Meta-Portfolio

Referencing the cluster analysis, you might combine a fast momentum tactical asset allocation portfolio with a slow momentum TAA portfolio and a trend-following Tactical asset allocation portfolio. Despite all being mechanical and momentum-based, they operate differently. The fast momentum strategy might use 1-month and 3-month momentum indicators, while the slow one relies on 12-month momentum. This creates diversification even within the momentum category.

The platform excels at combining multiple portfolios with clean, pre-tested data, eliminating the need to purchase external data for backtesting. You can easily find optimal allocations and adjust them to your preferences.

For example, we’ve built a portfolio consisting of four different tactical asset allocation strategies, initially allocating 25% to each. This meta-portfolio generates approximately 11.5% annualized returns with a maximum drawdown of 8% and a performance index of 3.83.

If we want to modify this allocation while keeping the same component portfolios, we can adjust the weightings, perhaps giving 40% to the Adaptive Asset Allocation strategy and 20% each to the others. The key performance indicators automatically update to reflect these changes.

Furthermore, you can optimize by trading each component portfolio on its historically best-performing day of the month. Instead of trading all portfolios on the 21st day, you might trade one on the 19th, another on the 20th, and so on. The model then recalculates allocations based on these trading days.

Tax Considerations and Retirement Planning

Tax Analysis for Different Account Types

If you’re trading your Tactical asset allocation portfolio inside a taxable account, the considerations are entirely different than for a non-taxable account. Capital gains treatment varies depending on how long you hold each asset class. In North America, long-term capital gains are taxed at a much lower rate than short-term capital gains.

You should know for each strategy, the percentage breakdown of:

• Short-term capital gains
• Long-term capital gains
• Dividends
• Interest
• Long-term capital gains plus dividends

This analysis helps you understand the tax implications of each strategy in both taxable and non-taxable accounts. When trading in a non-taxable account, you might prioritize the highest return or ultra-performance index (which factors in drawdown). However, for taxable accounts, the highest raw return might not be optimal if the strategy frequently trades and generates short-term capital gains.

For perspective, a strategy yielding 10% annualized returns primarily through long-term capital gains often proves more advantageous than a strategy delivering 14% annualized returns predominantly through short-term capital gains. Your tax bracket significantly impacts your actual returns, a crucial point often overlooked in financial discussions. The tax effect on returns can be substantial across all strategies.

Interest Rate and Currency Exposure

Interest Rate Exposure: Strategies are ranked based on their sensitivity to rising interest rates. Some strategies show as high as 77% exposure to interest rates, meaning they would likely underperform in a rising rate environment.

US Dollar Exposure: Similarly, certain strategies have significant exposure to the US dollar and would be affected by currency fluctuations. Understanding this relationship helps you prepare for various economic scenarios.

Conclusion

In today’s financial landscape, there’s no compelling reason not to invest in a TAA portfolio rather than simply allocating funds to the S&P 500. While the latter approach might have been adequate 10-20 years ago when we had limited knowledge and access to sophisticated tools, contemporary investors have affordable access to powerful analytical services and reliable signals.

Even selecting a relatively conservative option like the All Weather Portfolio outperforms the S&P 500 over the long term in any rolling period. The data clearly demonstrates that tactical asset allocation offers superior risk-adjusted returns compared to traditional strategic allocation approaches.

The three key benefits we’ve highlighted is systematic approach, dynamic allocation to top-performing sectors, and superior performance – make tactical asset allocation an essential component of a modern investment strategy.