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Given the preceding discussion, it appears that it will be very hard to make a convincing case for tactical asset allocation using alternative asset classes. However, a few observations may provide a basis for tactical asset allocation.

First, by focusing on a few asset classes, the manager might be able to develop separate forecasting models for each and therefore generate forecasts with independent errors. While FLOAM presents IC and BR as somewhat independent parameters, they tend to be dependent in practice. For example, it is highly unlikely for a manager to have the skill to forecast returns on a large number of independent securities. Notice that the key word here is independent. This means that the manager applies one or more models to a set of securities that are not highly correlated, and therefore the forecast errors are independent from each other. This is a very strong requirement that is unlikely to be fully satisfied. In other words, there is a negative relationship between IC and BR. The more markets to which the manager tries to apply her skills, the less accurate the forecasts are likely to become.

Second, the information coefficient tends to be much higher when applied to asset classes than when applied to individual securities. The random returns on individual security prices contain a significant amount of noise, which makes forecasting models less accurate. On the other hand, available empirical evidence suggests that expected returns on various asset classes or portfolios of securities behave in a more predictable way through various market cycles.11

Finally, while TAA may be difficult and costly to apply to alternative assets, TAA can be applied to the traditional portion of the portfolio, where derivative products can be used to significantly alter a portfolio's characteristics without having to redeem allocations to certain illiquid funds. For example, suppose the equity beta of a diversified portfolio of traditional and alternative asset classes is given by β_Port. This can be estimated by regressing the historical returns of the portfolio against the returns on an equity benchmark. The portfolio manager can reduce the equity beta of this portfolio by selling equity futures contracts. In particular, since the beta of a portfolio is equal to the weighted average of the betas of its assets, we have:

(2.3)

Here, β_New is the new beta of the portfolio, which could serve as the target by the manager, (F/P) is the ratio of the notional amount of the positions in the futures contracts to the size of the portfolio, and β_Futures is the beta of the futures contract with respect to the equity benchmark used to calculate the beta of the portfolio, β_Port. The beta of the futures contract is typically equal to one. An investor can engineer a new beta for the portfolio by adjusting the level of futures contracts, F.

APPLICATION 2.1.4

Suppose the beta of a diversified portfolio against the S&P 500 Index is 0.9. The portfolio manager wants to increase the beta to 1.2 because of improving economic conditions. If the market value of the portfolio is $500 million, what notional position does the portfolio manager need to take in the S&P 500 futures market with a beta of 1 in order to achieve a beta of 1.2? What position would have lowered the beta to 0.4? Inserting the known values into Equation 2.3:

That is, the manager has to take long positions in $150 million worth of S&P 500 futures contracts. If the manager had decided to reduce the equity exposure to 0.4, the futures position would have been:

In the second case, the manager has to establish a $250 million short position in S&P 500 futures contracts to lower the beta to 0.4 from 0.9.

Application 2.1.4 highlights an actual advantage that TAA may have when applied to broad asset classes: Portfolio managers may use liquid futures and swap markets to effectively implement the ultimate objective of TAA, which is to alter the portfolio's exposures to various sources of risk. This issue of factor exposures and factor investing will be further discussed later in the chapter.