On the information ratio of tactical asset allocation
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Mark Lundin is Head of Quantitative Research at Fortis Investment Management. Before joining Fortis, he held the position of research scientist at Olsen & Associates Research Institute for Applied Economics in Zurich. He has a PhD in particle physics from Universite´ Louis Pasteur, Strasbourg, France, a BS in mathematics and computer science from the University of Illinois and is a continuing faculty member of the International Faculty of Finance. Fortis Investment Management, Blvd. Roi Albert II, 1, 1210 Brussels, Belgium Tel: ⫹32 (0)2 274 8406; Fax: ⫹32 (0)2 274 9496; e-mail: [email protected]
Abstract The information ratio for tactical asset allocation strategies is derived under the assumption of dependence only on the information ratios for asset classes actively managed as sub-portfolios. If information ratios for security selection within asset classes are positive, then that for tactical asset allocation must also be positive. If information ratios for active management of the asset classes are equal, then they are also equal to the information ratio for tactical asset allocation. The overall information ratio for the global investment process comprising security selection and tactical asset allocation is greater than that of any single constituent. Keywords: tactical asset allocation, information ratio, active management
Introduction The process of asset allocation involves the distribution of portfolio value to different investment asset classes. Securities are grouped in these classes based on their fundamental similarities or on perceptions of significant correlation. Classic examples include stocks, bonds, real estate and cash. Main groupings are sometimes divided further into subclasses, for example domestic stocks versus foreign stocks, or government bonds versus corporate bonds. Investment diversification dictates that combining these classes will provide access to a more optimised risk premium. Investors and investment managers typically make a distinction between two types of asset allocation. Strategic asset allocation refers to the process involved with setting asset class weights, either permanently or for
326
Journal of Asset Management
what are foreseen to be long-term horizons. Tactical asset allocation is typically a reference to shorter-term deviations from strategically set benchmark weights and is also sometimes referred to as market timing. This discussion pursues the question of the value added by active management of asset classes, or tactical asset allocation. In doing so, we derive the tactical asset allocation information ratio as being dependent only on security selection skill. The ex-ante (or forward looking) definition of the information ratio connotes potential opportunity and is obtained via the fundamental law of active management (Grinold and Kahn, 1995). The law states that the information ratio (IR) is a measure of an investment strategy’s value added, which is equal to the product of skill and the
Vol. 4, 5, 326–333
䉷 Henry Stewart Publications 1479-179X (2
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