Here’s a question; is tactical or strategic asset allocation the best approach to portfolio management? 

Before we get to that question, here’s another; what is the difference between strategic and tactical asset allocation?

In both cases we are talking about asset mix with the context of a portfolio. With strategic asset allocation, we are talking about designing an asset mix based on the client’s objectives and risk tolerances. 

For example, Mr. Smith is 50 years old, married with two children and is saving for retirement. His goal is to retire at 60. While I recognize that we are merely scratching the surface as to what type of investor Mr. Smith is, we will for this example, assume that he is a balanced investor. 

If we look to the FPX indexes, then the FPX Balanced Index is a typical asset mix for this type of client. Given that, we can say that Mr. Smith’s strategic asset mix is 50% equity, 40% bonds and 10% cash. 

Having established a starting point, the long term management of this portfolio requires us to re-balance back to mandate either on a specific date, or as a result of specific variations within the asset classes. For example, let’s say that one year later, Mr. Smith’s portfolio is 60% equity – because the equity markets outperformed the bond market – 30% bonds and 10% cash. 

The re-balancing process would require the manager to sell equity down to the 50% mandate, and buy bonds, lifting the fixed income weight back to 40%. Think of this as strategic re-balancing. 

Tactical asset allocation follows a very different track. The tactical manager is not interested in the mandate of the client, but rather, is interested in weighting the portfolio so as to take advantage of current market conditions. 

For example, if a tactical manager believed that equities would outperform bonds over the next period - the period could be one month, one quarter, six months or even the one year – the manager would overweight equities and underweight bonds. 

Sometimes the tactical manager is constrained within a range of asset mixes. For example, the equity mandate might be constrained to say a 30% to 80% weighting. In this case, even if the manager believed that equities would out-perform, he could not hold more than 80% of the portfolio in equities. 

There are also tactical managers who have no such constraints. They may go to 100% equity, 100% bonds or 100% cash, depending on their view of the world. The point is, the tactical manager is not determining his asset mix decision based on the clients’ mandate but rather on the managers view of the likely performance of the various assets within the portfolio.

So which approach is better? Like most aspects of investing there is no right or wrong answer. The only way to view this, is to examine the process within the risk tolerance of the investor. In other words, I have difficulty supporting a tactical position if that is the only approach being used within an investors’ portfolio. 

To make that point, let’s return to Mr. Smith. I am not sure it would be appropriate for him to have a portfolio that was 100% invested in equity, which is precisely where a non-constrained tactical manager could be at a point in time. 

Further, because an un-constrained manager can actually hold 100% equity, I would prefer to assume that the manager will be 100% equity all the time. By doing that, it allows me to categorize the tactical strategy at is highest risk point, and that allows me to balance out the portfolio with other assets to provide some sense of strategic balance. 

For example, my company has a tactical asset allocation fund called the managed global mandate (MGM). The portfolio advisor is not constrained in this fund, and therefore, could hold 100% equity at a point in time. In fact, earlier this year, that is exactly where we were.

Now, if I have a smaller client – i.e. less than $150,000 in assets - who is a medium risk investor, I would use that fund as his core holding. However, for the medium risk investor, 20% of the portfolio would be held in bonds. By doing that, I have established for the medium risk client a strategic asset mix, that at its highest risk level (i.e. highest risk would occur if MGM was 100% invested in equity), would not expose the investor to more than 80% equity risk. 

So the answer as to which approach is best, comes down to understanding what each approach brings to the portfolio. And perhaps the best approach is one that combines both tactical and strategic asset allocation.

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Before we conclude this week’s column, I want to follow up on a couple of e-mails related to last weeks discussion about early RRSP withdrawals. 

A couple of readers asked about the concept of transferring Royal Bank shares – that was the example I used last week – from the RRSP to the non-registered account. When you make a withdrawal from your RRSP, whether in the form of a security or as cash, you must pay a withholding tax. 

I had suggested last week, that you could fund the withholding tax by using the excess margin in your non-registered brokerage account. The process would work like this. Your broker would simply transfer, in last week’s example, 300 shares of Royal Bank at $54 per share. The total value of this withdrawal is $16,200 and you would have to remit withholding tax. When your paid up Royal Bank shares are deposited into your non-registered margin account, you create excess margin which can be used to cover the withholding tax. Brokers should be able to accommodate this flow.

The objective, of course, was that our reader wanted to continue holding the same stocks that were in his RRSP, but wanted to shift the stocks from the RRSP to the non-registered account at a time when he was in the lowest possible tax bracket. Through this transfer process, our reader did not have to sell the shares and then re-purchase them.