Asset allocation refers to the percentages of investment capital put into the various types of investments. The goal with asset allocation is to achieve maximum return within an acceptable amount of risk.
There are four major types of asset allocation: Constant weight asset allocation, strategic asset allocation, dynamic asset allocation, and tactical asset allocation.
In this post, I’ll review these different types of asset allocation in relation to financial advisors, funds, and individual investors since the various models can be implemented by all three. If you’re an individual investor, this information will inform you about the investment strategies that you can use, as well as the strategies you might find if and when interviewing a financial advisor.
It is important to understand the 4 different types of asset allocation so you can choose the best approach for you to achieve your own financial goals. During over 40 years of investing my own money, I have used all four asset allocation methods but lean toward dynamic and tactical asset allocation now.
Constant Weight Asset Allocation
Constant weight asset allocation holds a fixed percentage in different types of investments based on various asset allocation factors. This type of asset allocation disregards economic and market conditions in making investment decisions.
An example of constant weight asset allocation might be as follows:
- Stocks 60%
- Bonds 40%
With constant weight asset allocation, portfolio holdings must be adjusted to bring the portfolio back to the desired percentages since asset values are constantly changing, with the exception of cash and money market accounts. This portfolio adjustment is referred to as rebalancing and it is typically done annually, although a fewer number of investors rebalance more frequently such as biannually.
A portfolio might end the year, for example, with the following allocation following a strong rise in stocks:
- Stocks 70%
- Bonds 30%
In this case, the investor would sell some of his stock holdings and buy bond holdings to bring the portfolio back to the original desired allocation. The main attribute of a constant weight asset allocation is that the asset allocation remains the same from year to year.
Of course, major life events such as retirement can call for a change in asset allocation. With a constant weight asset allocation, however, the change is due to the investor, not macro (large) economic or financial changes.
This type of asset allocation is often associated with the terms
- Passive investing
- Riding out the bear market
- Buy and hold investing
There are pros and cons of asset allocation using a constant weight method. Most investors use constant weight asset allocation due to its simplicity and low cost yet wealth building opportunities from economic changes or long term market cycles are missed.
Strategic Asset Allocation
Strategic asset allocation uses various asset classes to accomplish portfolio goals. The classic example of this is adding U.S. Treasury bonds to a stock portfolio since they are an asset that goes up when stocks go down.
Asset classes that move in the opposite direction of one another are called noncorrelated. This noncorrelation between the two assets decreases portfolio risk.
Other defensive investments besides bonds, such as gold or inflation protected bonds, are also used at times for risk management in many strategic portfolios.
Constant weight asset allocation is often used for strategic asset allocation and vice versa. These two types of asset allocation overlap but refer to slightly different objectives. The objective of constant weight asset allocation is to strongly adhere to a rigid allocation meant to keep an investor within defined risk parameters while reaching the desired goal while the structure of a strategic asset allocation should provide the framework to do so.
Asset class valuations and economic trends are disregarded with strategic asset allocation. Instead, this model focuses on how investments have moved relative to one another in the past.
|Type of Asset Allocation||Main Attribute||Usage||Considers Asset Valuations or Economy||Tax||Pro||Con|
|Constant Weighted Asset Allocation||Rigid Allocation||Very Common||No||Favorable||Easy to Implement||Limited Upside|
|Strategic Asset Allocation||Correlation of Asset Price Movement||Very Common||No||Favorable||Easy to Implement||Limited Upside|
|Dynamic Asset Allocation||Changes Due to Macro Factors||Somewhat Common||Yes||Not as Favorable||Can Capture Opportunities||Hard to Beat Benchmarks|
|Tactical Asset Allocation||Seeks to Capitalize on Opportunities||Least Common||Yes||Least Favorable||Expert Models Available||Hard to Beat Benchmarks (Unless Model Used)|
Dynamic Asset Allocation
Changes are made to an asset allocation based on changes in the economy or the markets when using dynamic asset allocation.
While constant weight asset allocation rarely has asset class percentage changes, dynamic asset allocation has more frequent changes when deemed necessary by the investor or financial advisor managing the portfolio.
Does Dynamic Asset Allocation Work?
It can be difficult to decide when to make asset allocation changes which will result in returns that beat passive investing models using a constant weight asset allocation. With dynamic portfolio moves, there is also pressure for financial advisors or fund managers to outperform a passive constant weight asset allocation portfolio since wealth management fees can be high, and asset allocation changes can trigger taxes.
Skilled investors and financial advisors, however, can enhance portfolio returns and/or lower stock market risk with dynamic asset allocation.
Carefully reviewing past performance for any fund using a dynamic asset allocation model will reveal the past success of the fund manager’s decisions. Individual investors can evaluate their own past investment decisions for what has and has not worked.
Example of Dynamic Asset Allocation
What would trigger a move in a dynamic asset allocation portfolio or fund?
A fund manager following a dynamic asset allocation method may, for example, notice an unusually high risk level in the stock market. Noticing this, she may increase the fund’s allocation into Treasury bonds from 20% to 40%.
Alternatively, the fund manager may increase an allocation from the U.S. stock market to emerging stock markets based on a global macro trend.
With dynamic asset allocation, asset valuations, and economic conditions are considered to get the best return within the specified risk parameters.
Dynamic Asset Allocation Funds
A quick Google search will reveal that many financial firms offer dynamic asset allocation funds. Such a fund is often called actively managed since the manager must make asset allocation decisions based on changing conditions.
Macro global change or disruptive technology may trigger dynamic asset allocation changes, for example.
Astute individual investors can also, of course, implement dynamic asset allocation strategies.
After my own online search for dynamic asset allocation funds, I investigated Putnam Dynamic Asset Allocation Growth Fund (PAEAX).
The results on the company website for this fund are in the image below. Note the top blue arrow is for the Russell 3000 Index which Putnam is using for the benchmark or comparison index. Notice, however, the ride looks smoother; that’s often the goal with dynamic asset allocation funds: less risk or capital preservation in financial lingo.
Tactical Asset Allocation
Tactical asset allocation takes advantage of potential opportunities due to changing pricing and valuations. The main difference between a strategic vs tactical asset allocation is that the asset allocation percentages change based on changing economic factors, similar to a dynamic asset allocation.
For example, a 55 year old investor may move to a higher portfolio cash allocation of 60% to lower stock market risk when market valuations become high based on historical levels. She may normally allocate only 55% of her portfolio to stocks given the short time frame before her retirement. After a major bear market, however, she may increase her stock allocation to 75% given that she can buy stocks at unusually low stock valuations.
Once stocks return to more normal valuations, she may return to a 55% capital allocation to stocks or pursue another asset class based on valuations and expected returns.
All of these portfolio allocation changes are tactical in nature.
Tactical Asset Allocation Models
Tactical asset allocation may be flexible and based on observation or based on a defined model.
For example, tactical asset allocation changes may be as simple as the one used by the astute stock investor above who wishes to invest a higher allocation in stocks due to lower than normal valuations, or they may be more structured.
Tactical asset allocation models have also been developed by expert investors, researchers, and quantitative analysts based on various factors such as pricing patterns and price movements among asset classes.
One benefit of a tactical model vs flexible implementation is that ETF’s are often used for tactical asset allocation models so such models can be back tested to analyze past performance results. This can be particularly useful when comparing the model history to the current economic climate and financial markets.
The goals of tactical asset allocation models can be based on better risk management through lower portfolio volatility, higher than benchmark (index) returns, or both.
Tactical Asset Allocation Example
Meb Faber, author of The Ivy Portfolio, a book on strategic asset allocation, has also been a pioneer in tactical asset allocation models. Results from 1973 through early 2022 for Faber’s EXD5 Tactical Asset Allocation model can be seen below.
Notice from the table below that the return (CAGR, Compounded Annual Growth Rate) isn’t as high as the S&P 500, but there was much less volatility with the tactical asset allocation because it moved out of stocks during long bear markets. The drawdown with this Faber tactical asset allocation model was -12.87% over 27.1 months while the S&P 500 drawdown was 55.25% over a lengthy 73.5 months for the same time frame.
This particular tactical asset allocation invests in various asset classes, including bonds. Therefore, the portfolio may well have beaten a fixed asset allocation portfolio with a blend of stocks and bonds, which would have been a more appropriate comparison to Faber’s model.
Fortunately, tools such as Allocate Smartly are now available for individual investors to analyze such strategies.
Tactical Asset Allocation Funds
Again, an online search will reveal there are tactical asset allocation funds as well as tactical asset allocation models that are used by both financial advisors and individual investors.
Tactical asset allocation covers a diverse collection of investment products and methods.
For example, both institutional and retail mutual funds may use tactical asset allocation that is based on a manager or other expert’s discretion.
Commonfund provides investment services to institutional investors. They define tactical asset allocation as “intentional market timing”. The tactical asset allocation factors they consider include:
- Global Growth
- Monetary Policy
- Yield Curve
- Equity Risk
- Leading Economic Indicators
Other tactical asset allocation models, such as the Faber model referenced in this post, are based on simple technical indicators.
Does Tactical Investing Work?
Remember, dynamic and tactical asset allocation models are associated with active vs passive investing since decisions are made to change the asset allocation based on economic or other reasons.
Over the years, studies have repeatedly revealed that the overwhelming majority of active (aka tactical) fund managers underperform passive fund managers. According to CNBC, only 11% of large cap funds with active management performed better than passively managed funds over a 10 year period based on a Morningstar report.
Tactical mutual funds evaluated in another Morningstar report entitled Mind the Gap did not outperform a more traditional passive buy and hold asset allocation. over a 10 year period ending March 2018…
…“the average tactical fund’s asset-weighted investor return lagged its total return by 1.96 percentage points annually…The average return gap across all U.S. funds measured 1.37 percentage points over the same 10-year period.”
Morningstar also reported that downside risk was not better with tactical funds, either, based on the study.
“During the 15 years through December 2018, the average fund in the tactical-allocation category tended to lose 5% more than Vanguard Balanced Index in months that the Vanguard fund posted negative returns.”
Return and drawdown data such as that seen for the Faber tactical asset allocation referenced elsewhere in this post reveal a lower return than the S&P 500, but the drawdown was dramatically better and shorter by a large enough margin to be a good tradeoff for most investors.
Other data exists showing tactical asset allocation models that outperform passive index portfolios with better drawdowns.
The answer to whether tactical asset allocation works is that it depends on the strategy or method of tactical asset allocation being used.
Tactical asset allocation being implemented with the macro factors used by commonfund simply doesn’t compare to a quantitative tactical asset allocation based on technical indicators. Even though they are both referred to as tactical asset allocation strategies, they are two entirely different constructs. The commonality is that neither uses a rigid asset allocation.
The conclusion based on my own research and investing is that tactical asset allocation does occasionally work, at least for some models.
Tactical Allocation ETF
In addition to managed tactical asset allocation funds, many ETFs based on tactical asset allocation also exist.
According to ETF.com, the total assets under management in tactical ETFs is $2.86 billion.
Is Tactical Asset Allocation Contrarian?
Many investors believe that tactical asset allocation is contrarian. It is contrarian from the standpoint that most investment strategies follow a constant weight asset allocation that incorporates a strategic element.
Many tactical asset allocation models, however, are momentum based. As such, these models shift from less popular assets to increasingly popular assets; this is the opposite of contrarian.
Does Tactical Asset Allocation Add Value?
It appears that tactical asset allocation can absolutely add value when it works. It makes sense that investors who increased their allocation to stocks in March of 2009 would have come out ahead by doing so.
What is the Difference between Dynamic and Tactical Asset Allocation?
Tactical asset allocation and dynamic asset allocation are very similar almost to the point of being used interchangeably. They both invest based on economic or market conditions vs using a fixed asset allocation that disregards these important factors.
There are a couple of differences, however, between the two.
First, dynamic asset allocation is often in place longer term than tactical asset allocation.
Tactical asset allocation also tends to be based on asset pricing changes whereas dynamic asset allocation changes are made due to macro factors.
Do Financial Advisors Use Strategic or Tactical Planning?
Many financial advisors use institutional funds like the ones referenced earlier. Other financial advisors invest in other types of assets.
Financial advisors vary in the type of asset allocation they use. Many financial advisors like to adhere to a constant weight asset allocation while others prefer to make changes to the portfolio. The asset allocation model used is often based on whether or not an advisor is affiliated with an investment firm and the policy of the firm.
The Best Type of Asset Allocation for You
My observation is that most investors are happy with a simple constant weighted portfolio during years of economic expansion and accompanying bull markets due to the high allocation in stocks that most asset allocations have. After a secular bear market, however, investors often prefer an asset allocation that considers market valuations and economic conditions.
Only you can decide the best type of asset allocation for you based on your own investing style, desired return, and risk tolerance.
A personal wealth plan will help you clarify these factors and choose wisely.
Sources for this post: