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Mercer
Investment consulting, alpha alternatives

Contact: Linda Russheim
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What is Global tactical asset allocation?


Written by: Ralph Frank

 

Managing Risk
Active Currency
Global Tactical Asset Allocation

> Global Macro Hedge Funds

> TAA activity within multi-asset funds

> How can investors use GTAA

> GTAA funds

> GTAA overlays

> Why invest in GTAA

> Conclusion

Hedge Funds
Equity

GTAA (Global Tactical Asset Allocation) is an investment strategy that attempts to exploit short-term market inefficiencies by taking positions in various markets with a view to profiting from relative movements across those markets. The approach focuses on general movements in the markets rather than on performance of individual securities within them Positions are generally taken with a relatively short-term time horizon (3 – 6 months) – hence the term Tactical Asset Allocation – and in markets across the globe – hence the term Global.

 

Positions are invariably implemented via derivatives, for example, selling futures on markets expected to underperform and buying futures on markets expected to outperform.

 

Traditionally, positions have been largely limited to major world equity and bond markets as well as currencies. More recently, many managers have broadened their opportunities set, and strategies may now include any of the following: emerging market equities, debt and currencies, commodities, industries/sectors of equities markets, large vs . small equities, credit spreads and yield curves.

 

GTAA shares some of the characteristics of, or can be seen as having developed from, Global Macro Hedge Funds and tactical asset allocation (TAA) decisions implemented by managers of multi-asset or balanced funds.

 

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Global Macro Hedge Funds

Like GTAA, Global Macro Hedge Funds aim to profit from taking positions in major world equity, bond or currency markets. Global Macro, however, has been characterised, at least in public perception, by large, undiversified bets, for example Soros vs . the Bank of England. Modern GTAA strategies are generally well-diversified and operate with strong risk controls.

 

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TAA activity within multi-asset funds

TAA decisions undertaken by managers of multi-asset funds are, like GTAA decisions, intended to enhance investment outcomes by overweighting and underweighting asset classes, depending on the expected future performance over relatively short time periods. TAA within multi-asset funds is, however, limited to the asset classes contained in the fund’s strategic asset allocation, whereas most GTAA strategies access a broader opportunity set. Also, GTAA is being undertaken as a specialist activity by teams applying substantial resources to the task. TAA decisions implemented within multi-asset funds were in the past frequently taken by committees of asset class specialists primarily focussed on managing portfolios in their respective asset classes.

 

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How can investors use GTAA

Investors can incorporate GTAA into their investment structures either by investing in a GTAA fund or by utilising a GTAA overlay service.

 

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GTAA funds

These funds typically incorporate a high degree of leverage and therefore generally have demanding investment objectives with corresponding high volatility. For instance, an investment objective of cash plus 15% pa and expected volatility of 15% pa is common. Accordingly, even if the proportion of a plan’s total assets invested in such a fund is small, the potential return (and contribution to risk) at the overall plan level can be significant.

 

Due to the volatility, we normally recommend that the allocation to GTAA funds be limited to a small proportion of total assets (up to 5%), although this depends on risk appetite and the specific risk budget of the pooled fund. The investment should ideally be spread across 2 – 3 funds to enhance diversification.

 

Compared to overlays, the key advantage of GTAA funds is their administrative simplicity. Indeed, the mechanics are similar to investing in any pooled investment vehicle. Some funds are, however, domiciled in offshore locations, and this may raise unusual due diligence issues.

 

The main drawback is that it is not possible to tailor the strategy to an investor’s particular circumstances. This drawback is becoming of less relevance over time as an increase in the number of credible funds is providing greater choice for investors.

 

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GTAA overlays

Under a GTAA overlay, a manager is appointed to manage a portfolio of derivatives contracts, which are entered into in the plan’s name. A cash balance of 2 – 3% of plan assets is allocated to the manager for the purpose of meeting deposits and margin calls on those contracts. If desired, this cash can be equitised .

 

Arranging and monitoring it over time is more complex than investing in a GTAA fund. As well as an Investment Management Agreement with the manager, credit limits must be established with counterparties to the derivatives transactions and a custodian is required to settle trades and report on positions.

 

The main advantage is the flexibility to tailor the mandate to the investor’s particular requirements.

 

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Why invest in GTAA

It is widely acknowledged that many institutional investment portfolios remain dominated by equity and interest rate risk, and that these allocations tend to remain static over time irrespective of market conditions. Unless a strict liability matching approach is to be taken, there is merit, therefore, in establishing a portfolio of alternative alpha sources.

 

We consider that GTAA represents an attractive alpha source for the following reasons:

 

  • The performance differentials between asset classes are frequently substantial.

  • The derivative instruments used in GTAA are mostly highly liquid and transaction costs are low.

  • The volume of assets managed with a focus on relative performance of asset classes is low compared to that focussed on finding opportunities within asset classes.

  • A number of managers with very impressive teams, processes and track records can be identified. There are many managers with less impressive credentials also – no surprises there.

 

Furthermore, the analysis and decision making involved in GTAA is focussed on cross-market comparisons. This is very different from the comparison of securities within given markets, which is the focus of active management within traditional asset classes, and of many hedge fund strategies, for example, market-neutral, convertible arbitrage. Accordingly, GTAA should be a good diversifier, particularly within an alpha portfolio.

 

In addition, with the widespread adoption of sector specialist investment arrangements, the TAA function previously performed by balanced managers is no longer provided for. Balanced managers’ TAA decisions have, in many cases, not been particularly favourable over time. Nevertheless, given the acknowledged importance of asset allocation, many trustees will draw comfort from having an element of TAA expertise deployed within their investment structures. And we consider that the use of leading specialist GTAA managers is a vastly preferable way in which to access this expertise.

 

Many of the arguments favouring GTAA also apply to active currency management. GTAA managers have a broader opportunity set than that available to a currency manager. Indeed, GTAA managers invariably include currency as part of their process and often expect to source around 30% of their value added from currency decisions. Provided that the manager’s skill in currency and in broader GTAA decisions is equal, the broader opportunity set in GTAA can be expected to lead to more reliable added value.

 

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Conclusion

GTAA strategies provide investors with a series of exposures that may not otherwise be present in their portfolios. Managing these exposures, which are usually in liquid markets with low entry and exit costs, provides an opportunity for the generation of active returns that are likely to be lowly correlated with other sources of active return. However, specialist skills are required to access these opportunities.

 

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Mercer is a leading global provider of investment consulting services, and offers customized guidance at every stage of the investment decision, risk management and investment monitoring process. We have been dedicated to meeting the needs of clients for more than 30 years, and we work with the fiduciaries of pension funds, foundations, endowments and other investors in some 35 countries. We assist with every aspect of institutional investing (and retail portfolios in some geographies), from strategy, structure and implementation to ongoing portfolio management. We create value through our commitment to thought leadership; world-class, independent research; and top-notch consultants with local expertise.