The idea that 90% of investment returns can be attributed to asset allocation is often bandied around in the investment world. But is it a myth, or cemented in truth? The answer, it seems, is not black and white.
Hargreaves Lansdown head of research Mark Dampier (above)believes that the importance of asset allocation is not necessarily a myth and can explain a lot.
‘But the trouble with asset allocation is that most people get it wrong. So while asset allocation explains the movement, it doesn’t mean that by allocating assets you make more money. It’s notoriously difficult to do,’ he argues.
The birth of a myth
The statement of asset allocation’s relative importance has its roots in a landmark US study carried from the 1980s. However, there are claims that the research is frequently misquoted, and some advisers finding the 90% figure difficult to believe.
The Determinants of Portfolio Performance research carried out by Brinson, Hood and Beebower and published in the Financial Analyst Journal in 1986, found that the percentage of the variability of a portfolio’s return over time that could be explained by asset allocation policy was over 90%.
An update on this research published in 1991 by Brinson, Singer and Beebower found a similar result, with both studies also reporting that the percentage of the level of total long-term returns that could be explained by asset allocation was over 100%. Both studies focused upon US balanced pension funds.
Another empirical work in this area was published in 2000 in the same journal by Ibbotson and Kaplan entitled Does Asset Allocation Explain 40%, 90% or 100% of Performance?
This report states that the Brinson studies are often misinterpreted and the results applied to questions the studies did not address. This includes explaining the importance of asset allocation to the variation of performance among funds, or what percentage of the level of a typical fund’s returns can be attributed to asset allocation policy.
Ibbotson and Kaplan found that strategic asset allocation explains around 90% of the variability of a typical fund’s returns over time, but accounts for only around 40% of the variation of returns among funds. On average across funds, asset allocation explained just over 100% of the level of long-term returns, according to a review of leading academic studies by Pan-Asset Capital Management.
Hard to swallow
Advisers typically believe in the importance of asset allocation, but some find the simplified statement that 90% of returns can be put down to asset allocation, hard to swallow.
Premier Wealth Management managing director Adrian Shandley says: ‘You tend to find that the people who bandy this around are the same people who have fund platforms or bonds with multi-manager.’
He suggests when research on asset allocationis carried out, issues such as charging and market timing can be precluded.
‘If you’re looking at a benign, clinical, scientific world, then that 90% is probably true,’ Shandley adds.
‘What you then have to do is transpose the client into the real world, where we’ve got charges, timing and volatile events.
‘To isolate asset allocation as one thing that is worth 90% of the overall returns is far too simplistic.’
The bigger picture
Ken Rayner of financial consulting and research firm Rayner Spencer Mills, believes in the concept of asset allocation, but offers similar scepticism about the 90% figure.
‘I think it’s a myth that 90% of returns come from asset allocation, but I do think some of the returns come from there,’ he notes.
He believes it is difficult to predict the economic changes that are about to take place and therefore both asset allocation and choosing the right stocks and funds underneath are important.
‘It’s difficult to say you’re going to be accurate in predicting that macro picture any more than you will be picking the funds or the stocks. So I think you have to work at both to achieve the end goal,’ Rayner says.
‘Even if it was a fact that 90% of returns come from asset allocation, you probably couldn’t achieve that anyway. You would be very lucky to get 50%, so you have to get a bit from both in order to get somewhere close to it,’ he explains.
However, when considering the 90% as the variability of return as the Brinson, Hood and Beebower research suggests, Pan-Asset Capital Management chief executive Robert Brown finds this figure ‘very believable’.
He suggests the studies in this area show how stock selection detracts from performance, leaving returns to come from asset allocation.
‘In a way that’s stating the obvious,’ he says. ‘If you decide to buy equities and they get 20% when your cash at the bank would have just given you 5% – that’s the big decision. And because the index has gone up, 20% is the average experience. So the real money is made in the decision to get into equities. On average you can’t make money by stockpicking because, by definition, the index is the average.’
Brown also points out that many of the studies into the role of asset allocation in producing returns, including the Brinson, Hood and Beebower work, only look at the US equities, bonds and dollar cash asset classes.
He adds: ‘Now that the asset allocation choice is so much broader, there must be far more opportunity than ever before.’
Brown describes stock selection as ‘scarcely worth bothering about’.
Open to interpretation
For Gavin Haynes, managing director of Bristol-based Whitechurch Securities, getting the right asset allocation is crucial to providing a well-balanced portfolio. However, putting an exact figure on just how much of returns it is responsible for he describes as very difficult.
‘I don’t think a successful investment portfolio means shifting the asset allocation dramatically in a tactical manner. The key thing is we see asset allocation as being very much client-focused and the allocation is very much dependent upon the client’s investment objectives and the risk they are prepared to take to achieve that return,’ he says.
While few doubt the importance of asset allocation, the exact extent of its effect on returns remains open to interpretation.
