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What are the main asset allocation styles used by mutual fund managers?

Strategic asset allocation

Many balanced fund managers use strategic asset allocation to keep a fairly stable mix of equities, fixed-income and cash. The amount of each asset class in the mix is fixed within certain ranges, reflecting the manager's long-term expectations for which combination of the three asset classes will produce the return and risk best suited to an average conservative investor. There are different ways to estimate future returns on the three main asset types. Investment management firms often use sophisticated models. Security prices can also be forecast using historical returns. Stocks have historically produced the highest average returns over the long-term. Fixed-income investments, like bonds, have historically have earned lower long-term returns than stocks, while safe cash investments like treasury bills have generated the lowest returns. Another important feature of the three different asset classes is that they generally perform well at different times. When stocks are doing well, bonds are doing less well and cash assets even more poorly. When stocks are dropping, bonds are generally rising. That's why a balanced fund manager who chooses an asset allocation of 70% equity, 20% fixed-income and 10% cash can expect to earn a higher return over the long-term, but with a higher level of risk to the portfolio because of the heavy equity weighting. An allocation of 45% equity, 45% bonds and 10% cash would be expected to lead to a more balanced long-term return because of the equal weighting of equities to fixed-income securities. There will be times when the weighting of one or more asset classes falls out of line with the strategic mix. This might happen due to a particularly strong or weak performance in one of the asset classes. Generally, managers will rebalance their portfolios when there is a 5% variance in their strategic allocation.

Tactical asset allocation

In contrast to many balanced fund managers, asset allocation funds generally use a tactical asset allocation approach. Tactical asset allocation managers typically have leeway to make wholesale short-term shifts between asset classes before returning the portfolio back to its strategic mix. A manager who believes stock prices will fall would generally move heavily into fixed-income and cash assets. If the manager's call on the market is right, then the fund will record superior returns. Of course, if the prediction is wrong, then the fund could be staring at large losses, or, at the very least, a missed opportunity. Tactical asset allocation is grounded in the belief that the ups and downs of the stock and bond markets can be anticipated. In reality, though, it's extremely rare if not impossible for managers to consistently make correct calls on the market. They may be right on some occasions, but they will likely make the wrong move on others. This means tactical asset allocation typically leads to more volatility in the portfolio. However, this increased risk generally does not lead to higher returns in the long-term. In a 1998 Canadian Securities Institute study of historical mutual fund returns in Canada, it was found that asset allocation fund managers typically did not compensate investors with higher returns for the extra risk. Still, this doesn't mean you should write off all tactical asset allocation funds. There are always exceptions. You may discover a fund manager who has been able to compensate investors with higher returns. Indeed, the same study that criticizes asset allocation managers also finds that managers who find a winning formula tend to repeat their good performance in future years.