Tactical asset allocation using the Kalman filter

Abstract

Tactical asset allocation (TAA) is a dynamic investment strategy which seeks actively to adjust fund allocation to a variety of asset classes by systematically exploiting inefficiencies and temporary imbalances in equilibrium values. This approach contrasts with strategic asset allocation (SAA) in which a long-term investment view target allocation is established using a combination of target return and risk tolerance. Asset returns are forecasted using the Capital Asset Pricing Model (CAPM), complemented with results obtained from the Kalman filter. Performance of TAA and SAA approaches are compared using several diagnostic metrics. The TAA approach outperforms its SAA counterpart for most of these metrics for the period under consideration, showing some potential benefits of using this approach.