Paper Example on 3 TAA Strategies: Static, Reactive & Anticipatory

There are three TAA alternative approaches. These approaches are static strategy, reactive strategy, and anticipatory strategy.

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Static strategy -This is a passive strategy that can maintain a static portfolio mix.

Reactive strategy - it is a strategy where an investor uses the events that have already happened to make investment decisions of a portfolio. In other words, the beta is used to make various investment reactions.

Anticipatory strategy - this approach deals with shifting funds before the market's movements. It is a forward-looking strategy, and it uses the parameter "alpha" (Lumholdt & Weis, 2018). Normally, the main purpose of this strategy is outperforming the portfolio without the Tactical Asset Allocation (TAA).

The Risks Shared Across the Three Alternative Approaches

Market risk is one of the risks that is shared across the three approaches. Market risk refers to the risk of the value of the investment declining due to various economic developments or factors that affect the entire market (Aswath, 2016). When the market risks occur, the value of the portfolio is most likely to develop despite the strategy used to maximize the portfolio returns. For instance, when the investor is using a static strategy, and the market risk happens, the value of returns will decrease but at a constant level. When the reactive strategy is applied, the returns still decline with slight deviations from the allocated beta. On the other hand, with the anticipatory approach, the value of alpha also reduces, and therefore the changes in the portfolio returns are lower when the market risk occurs.

It is important to note that market risk occurs in three types, which affect the three approaches. These types are equity risk, interest rate risk, and currency risk.

Equity risk is the risk that causes fluctuations in shares prices, and it is determined by the demand and supply of shares in the stock market (Graham & Harvey, 2018). It is a great risk because, in most cases, it leads to a decrease in the market shares prices. Other factors result in equity risk apart from the demand and supply of shares. For instance, natural calamities that directly affect economic activities create equity risk. For example, the coronavirus outbreak has affected all the global economic activities, and therefore most of the stock exchange markets are suffering huge losses. Notably, none of the three approaches above was able to prevent the current losses, which are a result of equity risk in the stock markets.

Interest rate risk mainly affects debt investments such as bonds. Normally the bond value drops when the interest rates increase (Hoffmann et al., 2019). As a result, the investors lose their money. The static strategy is a victim of this risk because it normally assumes the interest rates of debt investments to be constant, which is not always the case. The reactive strategy leads to losses because the past predicted interest rate might vary significantly from the current or future interest rate. Finally, the anticipatory approach may lead to overvaluation or undervaluation of the expected interest rates; hence, the lower value of the bonds.

Currency risk is a market risk that affects the value of foreign investments. Normally the value of the investments declines because of the changes in the exchange rates of the currencies (Iqbal, 2017). For instance, if an American investor has invested in a company whose stocks are valued in the Canadian Dollar, the investor will incur losses when the US dollar losses value. The exchange rates are always fluctuating. Therefore, none of the three approaches can effectively predict the future values of foreign investments. In conclusion, static, reactive, and anticipatory approaches are prone to currency risk.

Idiosyncratic risk of each approach

Static approach - its main risk is reinvestment risk. Since the approach involves constant changes in the portfolio, money is lost when the initial principal is reinvested in portfolios with a lower interest rate. As a result, the returns will be lower hence the loss.

Reactive approach - this approach experiences inflation risk because the "beta" parameter does not consider the changes in the inflation rate (Iqbal,2017). Therefore, there is a high possibility the investments have a lower monetary value when the investment period is longer because of the increasing inflation rate.

Anticipatory approach - this approach is affected by horizon risk, which occurs when the investment duration is shortened due to unpredictable circumstances. Horizon risk lowers the value of the portfolio because the investment is terminated before the predicted duration, and in this case, the "alpha" parameter caused overvaluation.

Three concepts are involved in the Tactical Asset Allocation (TAA) strategy. These concepts are the normal mix concept, the mix/exposure range concept, and the swing component concept.

Normal mix concept - refers to each asset class benchmark proportion that it constitutes in the portfolio. The expression of this proportion is an index or a fixed per cent of allocation. It is important to note that to maintain a fixed rate exposure, some rebalancing and management are performed.

Mix/exposure range concept - this concept explains that the extent of the current mix is likely to deviate from the normal mix. In other words, it provides the "reaction room" or the range for differences of the normal mix as compared to the current mix.

Swing component concept - this concept refers to the total portfolio's composition percentage change of the asset class. In other words, the component enables the investor to predict the possible percentage change of each asset class as compared to the entire portfolio. Notably, TAA's main feature is making proper swing component investments.

Application of The Three Concepts to Intuitive TAA Program

Before application, it is essential to understand that an intuitive approach refers to a scenario where an investor decides to invest in various asset classes based on personal opinion and gut feeling (McGee, 2016).

Application of normal mix concept - the investor makes his investment decisions based on the index or the fixed % allocation that is present in the stock markets for a given class of assets at a given period. For instance, if the investor's gut feelings convince him that a given asset class index is likely to increase the portfolio risk in the future, the investor is expecting more returns. As a result, the investor is likely to buy those shares.

Application of mix/exposure range concept - the investor considers both the normal mix and the current mix of a given class of assets. If the deviation is high, the investor might avoid investing in an asset class with a high deviation. On the other hand, the investor may invest in the class whose current mix deviation from the normal mix is likely to lower. The investor makes this decision based on his personal opinions regarding the investment.

Application of swing component concept - the investor considers his intuitions about the extent of percentage change of the asset class before investing. If the investor feels that there will be a positive percentage change of the portfolio returns in the future, the investor purchases the assets. However, if the investor has a negative intuition about the percentage change, the investor avoids investing in the portfolio to prevent losses.

Application of The Three Concepts to Quantitative Approach TAA Program

Unlike the intuitive approach, the quantitative approach relies on the managers' analytical assessment and a system to implement the precise portfolio changes (Faber, 2017).

Application of the normal mix concept - the managers use the S& P 500 index to analyze the possible returns of other companies' bonds and shares that the investors are interested in.

Application of mix/exposure range concept - the managers use the possible deviation of the current mix from a normal mix of S&P 500 shares or AAA corporate bonds to make investment decisions on various asset classes.

Application of swing component concept - the managers' investment decisions are based on analyses of the portfolio percentage change of the AAA corporate bonds or S&P 500 shares against the portfolio under review.

Definition and Explanation of Over-Trading Risk

Over-trading risk refers to the risk of an investment trader buying or selling excess stocks and bonds at a given particular period due individual opinions or analytic views of the trends in the financial markets (Phan, Rieger & Wang, 2018).

Effective understanding and identification of over - trading risk plays a vital role in trade optimization. Notably, trade optimization refers to the selection process of the best portfolio from a set of all the portfolios to meet the investors objective (Nystrup, Madsen & Lindstrom, 2018). In other words, consideration of the portfolio weights is a significant practice during trade optimization. Therefore, in the context of optimization, an investment trader is likely to be tempted to overbuy or over-sell certain asset classes depending on the prices in the market (Reichenecker, 2018). For instance, if financial market index of S&P 500 indicates potential value increase of certain class of shares in X future period, the trader will over-buy the assets in that class with the hope of selling them at a higher price in future.

On the other hand, if the market index portrays fall in stock and bond values soon, the investment trader is likely to sell all asset classes with the fear of making losses. Often over-trading risks result in large losses when the market trends occur differently from the earlier predictions of the trader (Kissell, 2018). For example, a trader might regret overselling certain asset class after the value of the particular assets increase sharply within a short period after the extreme sale. For example, an investor who excessively sold his stocks and bonds in the China investments in January 2020 after the announcement of COVID-19 in china is regretting the decisions in April because the prices of the financial assets are increasing sharply in the China stock exchange market.

Trade Efficiency Measures

The trade efficiency measures to monitor when executing a TAA are LVAR and VWAP measures. VWAP is an effective measure because it allows traders to integrate trading and investment strategy (Cartea, & Jaimungal, 2016). The investment decision is mainly based on the frontier of risk /reward tradeoffs. On the other hand, the LVaR measure considers the price available at the given time of order submission as the benchmark mark price (Al Janabi, 2019). In other words, the investment decision is executed on according to the larger number of small trades.

Mixed TAA refers to the portfolio that contains a mix of bonds and equities. Secondly, it is important to understand that combination of the intuitive and quantitative approach in the selection of classes of assets means using both the personal opinions/gut feelings and managers analytical skills in the selection of asset classes. Therefore, during the application of VWAP in executing of TAA, the investor seeks to identify the average price of the equity or bond within a given trading horizon (Crane,2019). Note the trade horizon under consideration is normally one day. Notably, the LVAR measure is used to evaluate the liquidity- adjusted VAR of each of the asset classes under consideration. Simply the LVAR establishes the amount of loss likely to be experienced with the easiness of buying or selling a certain asset class in the market (Wang, 2017). Therefore, LVAR...