Does tactical asset allocation work? Another look at the fundamental law of active management

Hubert Dichtl and Wolfgang Drobetz

Journal of Asset Management, 2009, vol. 10, issue 4, No 4, 235-252

Abstract: Abstract The performance potential of forecasting-based tactical asset allocation strategies is difficult to assess. The fundamental law of active management suggests that the value added through active investment decisions depends on the forecasting quality and the number of independent forecasts. Although easy to use, the law depends on several specific assumptions that are not fulfilled in practice. Therefore, it is not clear ex ante whether the actual performance of tactical asset allocation is close to what the fundamental law predicts. Using a simulation approach, we quantify the entire distribution of information ratios, active returns and tracking errors under realistic conditions (for example, with transaction costs and tactical bounds rather than a simple mean-variance optimisation). Our results reveal that the fundamental law systematically underestimates the required forecasting quality to reach a very good information ratio. While all other assumptions of the law seem innocuous, transaction costs are responsible for most of the wedge between the law's prediction and the performance of tactical asset allocation in a realistic setup. Our results are robust for stock and bond market data from different countries.

Keywords: tactical asset allocation; information ratio; fundamental law of active management; forecasting; simulation; distribution of performance measures (search for similar items in EconPapers)
Date: 2009
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Citations: View citations in EconPapers (1)

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DOI: 10.1057/jam.2009.6

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