I am designing an asset allocation strategy/fund which invests in four asset classes (via four independent sub-funds):
- Domestic equity
- International equity
- Domestic fixed income
- Foreign currencies
The strategy must be fully invested in these four funds at all times. I already have a default "strategic" allocation to the four funds based on our baseline views for the performance of the four asset classes. The managers of the strategy may, at times, have tactical views on relative value between
- Domestic equity and fixed income
- International and domestic equity
- The broad direction of foreign currencies (relative to USD)
Managers express their tactical views discretely on a 5-point scale from strong sell to strong buy (where buy/sell refers to the first of the two asset classes in the pairings).
The catch is that the view on international vs. domestic equity relative value is best seen as a view on currency-hedged relative returns, whereas the international equity fund is not currency hedged. The currency fund's holdings do not correspond exactly to the currency exposures of the international fund, but they are close.
My job is to research how and how much to shift from one fund to another in response to the manager's views. For the purposes of this problem, it is reasonable to assume we have standard mean-variance preferences. I must also take into account transaction costs, which are rather large. Hence tactical moves must be relatively long-lived and stable.
Any ideas on how to approach this problem? How should I calculate the tradeoffs between various asset classes?