Using a Value at Risk Approach to Enhance Tactical Asset Allocation

Abstract

This article presents a simple approach of incorporating a Value at Risk (VAR) constraint to tactical asset allocation (TAA). We outline a dynamic VAR TAA strategy that is useful in controlling the risk and expected losses of any balanced product. From our results it is evident that controlling losses can improve returns and at the same time reduce risk. The attractive feature of the strategy is that it is easy to implement and does not require assumptions about the distribution of returns or estimating investors' utility functions. In summary, the strategy provides pension fund managers with prescribed tactical tilts in asset allocation that are consistent with their level of risk aversion. The VAR TAA strategy significantly outperforms the buy-hold strategy. This approach can be used as a stand-alone strategy or in conjunction with the views of a TAA manager. The article shows that combining the VAR TAA strategy with more traditional TAA strategies produces a more robust investment process with improved information ratios.

TOPICS: VAR and use of alternative risk measures of trading risk, pension funds, mutual funds/passive investing/indexing