TAA - Is It Applicable to Hedge Funds? Featured

Tactical asset allocation, a longstanding and widely utilized investment strategy, is typically employed in traditional asset portfolio allocation. In this discussion, we won't assess the effectiveness of TAA in the context of stock or fixed income portfolios. Instead, we'll closely examine its relevance for alternative investments, specifically hedge funds.

Delving into this topic seems to be very important today due to a common trend in the alternative investment landscape. It's not uncommon for investment boutiques to bring on board managers with backgrounds in stocks or fixed income. These managers often adopt the TAA techniques to hedge fund portfolios without understanding unique hedge fund problems. This usually leads to some surprising outcomes. Is the TAA framework applicable to hedge fun portfolios? Let’s find out.

A common definition of the TAA by Vanguard is as follows:

Tactical asset allocation [TAA] is a dynamic strategy that actively adjusts a portfolio’s strategic asset allocation [SAA] based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances in equilibrium values among different asset or subasset classes.

So, the first step of employing TAA is to create a portfolio of asset classes or subclasses based on manager’s strategic vision of future performance of these asset groups. We will skip the discussion of how to create asset classes portfolios, because it is irrelevant for our purposes. What is essential for our discussion – the second step when the asset classes of the model TAA portfolio are substituted by real assets specifically, hedge funds in our case. Replacing asset classes of a model portfolio by real investment assets is deemed valid under one assumption: the assets should exhibit a high degree of correlation with their respective classes or subclasses. To find out whether hedge funds exhibit a high correlation with their corresponding strategy indices we conducted the following study.

  • We selected hedge funds of major classes from the Eurekahedge database and calculated their correlations with respective strategy indices.
  • We deselected funds with statistically insignificant correlations.
  • We built distributions of returns for each fund strategy being analysed.

A few selected examples of correlation probability distribution function (pdf) charts and the summary table are shown below. 

Strategy Index Correlation
< 0 < 0.25 > 0.5 > 0.75
Long Short Equities Hedge Fund Index Long-Short Hedge Fund Index 46.4% 11.9% 1.7% 1.7%
Arbitrage Arbitrage Hedge Fund Index 5.8% 14.4% 66.0% 31.2%
Distressed Distressed Debt Hedge Fund Index 2.7% 23.8% 41.4% 7,5%
Event Driven Event Driven Hedge Fund Index 2.9% 23.1% 43.5% 9.2%
Emerging Markets Emerging Markets Hedge Fund Index 8,5% 30.0% 41.7% 12.2%
CTA CTA/Managed Futures Hedge Fund Index 15.4% 36.0% 39.2% 13.7%
Fund of Funds Global Fund of Funds Index 1.5% 8.4% 62.1% 9.3%

 

Take, for example, the most common Long/Short strategy. Only 1.7% of Long/Short funds show a relatively high correlation over 0.75 with the Long/Short strategy index. The CTA funds show even a high degree of negative correlations: 15.4% of CTAs are negatively correlated with the CTA index.

In summary, utilizing hedge fund strategies as asset classes for Tactical Asset Allocation (TAA) can be risky, as these portfolios may display significantly different risk-return profiles and exposures to macroeconomic factors compared to model TAA portfolios. The TAA (Tactical Asset Allocation) framework implies constructing investment portfolios based on asset classes of underlying instruments and short-term performance forecasting of the corresponding indices. Originated from the traditional asset classes, TAA is often used for hedge FoF construction. However, when applied to alternative investments, it presents a highly misleading concept:

  • Fund managers may use multiple strategies, which makes it difficult to categorize.
  • Hedge fund indices and their assigned strategy classes exhibit a range of inconsistencies and data biases (see Hedge Fund Data Biases).
  • The whole TAA framework relies on the style-weighted allocation (read index-weighted allocation) that predetermines allocation across individual funds. Since the majority of hedge funds are not correlated with their corresponding indices, the applicability of the TAA becomes questionable.

To address this problem, we have developed several portfolio construction frameworks more suitable to alternative investments. These frameworks don’t rely on hedge fund strategy classes, but instead focus on real exposures to macroeconomic factors. To learn more, join our Portfolio Construction and Optimization webinars.

The TAA framework is not suitble for constructing portfolios of hedge funds (hedge fund of funds).

 

  • JOIN OUR WEBINAR

    Tactical Asset Allocation: why it is inapplicable to hedge funds. Major problems and drawbacks of TAA for hedge funds. Analysis of correlations between individual funds and their indices.

    TAA Problems

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    TAA: its pros and cons
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    TAA: its pros and cons

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