TACTICAL ASSET ALLOCATION

Tactical Asset Allocation



Tactical Asset Allocation

In making their strategic portfolio decisions, pension funds are restricted by their liabilities. At the same time pension funds and other institutional investors can choose from a large menu of alternative asset classes that goes beyond the traditional T-bills, bonds and stocks. In this paper we extend the existing models for strategic asset allocation. We study the problem of an investor with risky liabilities that are subject to inflation and interest rate risk, who invests in stocks, government bonds, corporate bonds, T-bills, listed real estate, commodities and hedge funds.

Liabilities are a predetermined component in the institutional investor's portfolio. Since liabilities are subject to real interest rate risk and inflation risk, assets that hedge against long-term liabilities risk are valuable for an institutional investor. The hedging demand for alternative asset classes like credits, commodities, hedge funds and real estate will depend on the covariance between assets and liabilities at different horizons.

Our interest is in three questions: (i) What do the time series properties of returns on assets and liabilities imply for the covariances at different investment horizons? (ii) Do the alternative asset classes add value for long-term investors? (iii) What do these covariances imply for the difference between the strategic portfolio of asset -only and asset -liability investors? We examine time and risk diversification properties and also the inflation hedge and real interest rate hedging qualities of the different assets. We investigate how the investment horizon influences the importance of the liabilities, and in particular whether the benefits from long-term investing are larger when there are liabilities.

This study contributes to three strands of the literature: strategic asset allocation, asset -liability management, and the behavior of alternative asset classes. In the literature on strategic asset allocation many studies have shown that long-term decisions differ markedly from short-term portfolio rules if the investment opportunity set varies over time and the state variables that predict returns have strong autocorrelations. Brennan and Xia (2002), Lioui and Poncet (2001), Bajeux-Besnainou et al. (2003), Barberis (2000), Wachter (2002), Campbell et al. (2004), Campbell et al. (2003) are a few examples of studies that consider the long-term investor problem in different settings using variations in preferences and return dynamics. These studies consider the asset -only investor and an asset menu consisting of T-bills, bonds and stocks. Until recently, almost all regulatory frameworks and accounting standards did not require fair valuation of pension liabilities. As a consequence, strategic asset allocation decisions were commonly considered in an asset -only context. The recent shift towards fair valuation of pension liabilities has led to a revived interest in ways to deal with interest and inflation risk in an optimal portfolio choice.

In an asset -liability model Leibowitz (1987) and Sharpe and Tint (1990) introduce a single-period surplus optimization framework when there are pension liabilities. In a long-horizon model Sundaresan and Zapatero (1997) solve the asset allocation of a pension plan and relate it to the marginal productivity of workers in the ...