Today we celebrate the death of another myth–that asset allocation is responsible for 90% of your return–surprisingly done in by none other than Roger Ibbotson of Ibbotson Associaties, purveyors of the ubiquitous asset class return charts. This myth is particularly pernicious because it is used by strategic asset allocators of all stripes to imply that active management or stock picking doesn’t really matter–if you just allocate properly you will be fine.
There are two problems with the myth that asset allocation is responsible for 90% of your returns: 1) the original Brinson et al. (BHB) study actually said that asset allocation explained 90% of the variation in returns between two sets of institutional portfolios, and 2) even that was wrong. In his recent article in the Financial Analysts Journal, “The Importance of Asset Allocation.” Roger Ibbotson writes:
Surprisingly, many investors mistakenly believe that the BHB (1986) result (that asset allocation policy explains more than 90 percent of performance) applies to the return (the 100 percent answer). BHB, however, wrote only about the returns, so they likely never encouraged this misrepresentation.
Whether BHB ever encouraged it or not, the misreading of the results was seized upon by hungry marketing departments everywhere to serve their own purposes.
Calculating the actual impact of active management versus the impact of asset allocation is actually pretty tricky. There have been several different studies that address it and their numbers vary, depending on the time horizon and the type of portfolio. Ibbotson’s own research into this area concludes:
Ibbotson and Kaplan (2000) presented a cross-sectional regression on annualized cumulative returns across a large universe of balanced funds over a 10-year period and found that about 40 percent of the variation of returns across funds was explained by policy.
Clearly, 40% is a whole lot different than 90%. It turns out that active management and stock selection is way, way more important than the strategic asset allocation crowd would like to admit.
Tactical asset allocation and active management may have a major role if investor returns are significantly dependent not just on how you are allocated, but on exactly what you own and when. Ibbotson’s article points out that:
The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix. Instead, most time-series variation comes from general market movement, and Xiong, Ibbotson, Idzorek, and Chen (forthcoming 2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy.
The emphasis is mine, but the “replacing folklore with reality” phrasing is pretty strong for an academic journal. Modern portfolio theory and its near cousin, strategic asset allocation, however, seem to be dying a lingering death. It is still the dominant method of structuring portfolios, but clearly it is just as important to consider tactical asset allocation and to make sure that active management processes are robust. The next time you read the 90% number somewhere, I hope you will give it the consideration it deserves—none.
Determining that security selection is a big driver of returns does not mean that managers possess the skill to select those securities correctly and time the purchases and sales so as to improve returns. Remember that security is a zero- (or negative-sum) game. So if we set aside the BHB study, now what is the methodology we should use? Of course, active managers’ marketing departments are eager to seize on the cited Ibbotson study rather than the previous BHB study. Investors remain at the mercy of those they trust.
If the market goes up over time, security selection is not a zero-sum game. You may be referring to the mathematical truism that the aggregate of all investor returns will be the same as the market return.
Keep in mind that there is ample documentation that, as a group, most individual and institutional investors vastly underperform market returns (see DALBAR, for example). Index investors, by definition, cannot exceed market returns. Therefore, it is also mathematically the case that some managers are ending up with all of the excess performance that most individuals and institutions are giving away.
Some return factors, such a relative strength and deep value, have been shown to outperform over time-even by efficient-market types like Ken French. The fact that only a few managers perform this feat with regularity seems to have more to do with lack of execution that with the methodologies.
Oops. I forgot to write the word “selection” after “security.”
I find this very interesting, as I am in process of getting my Series 65 Lic. In the course material, there is a fair amount of material on this very topic and the Asset Allocation strategies-Tactical vs Strategic; Modern portfolio Theory etc. I guess I will have to understand it— pass the test—and then forget it?! Nothing ever will allow a portfoilio to perform to indexex if nothing is ever done.
The Strategic Asset Allocation is very important. But what is that “Asset Allocation strategies-technical versus Strategic”? From the theory the SAA (Strategy Asset Allocation) is for long time investment and the TAA (Tactical Asset Allocation) for short time investment. The custom benchmark is an asset allocation mix strategies with different weights for traditional Asset Class: Fix Income, Stock and Cash. In the praxis the fist step for Portfolio construction are the country and currencies selection. The Portfolio theory is easier as the praxis and all Portfolio Manager have the same big problem “Selection”. All the models are not robust and the results are wrong interpreted. In praxis Performance Contribution and Attribution give us the result. That is my opinion.
Since the long term is nothing but a string of short terms, how can it make sense that SAA is for the long term and TAA is for the short term? As Ibbotson’s own work shows, selection is responsible for a lot more of the return than often believed, whether you are looking at the long term or the short term.
If you want to find the truth, FOLLOW THE MONEY. Who published this article? Money Management firms……of course you need money managers. They know better than you what the market will do and when, they are in the club, the inner circle and you, well you’re not
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