A new analysis challenges the conventional wisdom that asset allocation explains 90% or more of investment performance.
In their new study, Roger G. Ibbotson and Paul D. Kaplan, both of Ibbotson Associates Inc., Chicago, contend the explanatory power of asset allocation on a fund's total return varies: It could explain 40% or 90% or more than 100%.
Messrs. Ibbotson and Kaplan attempt to dispel misinterpretations of a 1986 study, led by Gary P. Brinson, on the importance of asset allocation, while they extend the meaning of that earlier research.
What it really said
The often-cited 1986 study -- written jointly by Mr. Brinson, L. Randolph Hood and Gilbert L. Beebower -- actually said a fund's return due to strategic benchmark asset allocation explains "on average 93.6% of the variation in total plan return." A followup 1991 Brinson study put it at 91.5%.
Messrs. Ibbotson and Kaplan contend the power of asset allocation depends on:
* how active the fund is in switching from its target asset allocation. The explanatory power for pension funds and balanced mutual funds ranged widely, depending on their willingness to be active.
* the type of fund. Results on average for balanced mutual funds were lower than for pension funds.
* how the question is phrased. In fact, in a related question, they found the policy asset allocation benchmark accounts for a little more than all, or 100%, of total return.
Messrs. Ibbotson and Kaplan also conclude the average pension fund and balanced mutual fund fail to add value because of market timing, active security selection or manager selection, and fees and expenses. The funds don't, on average, add value above their policy benchmark asset allocation, they write.
Mr. Ibbotson, chairman of Ibbotson, also is a professor in the practice of finance, Yale School of Management, New Haven, Conn. He has co-authored two books on investing with Mr. Brinson, who is chief investment officer of Brinson Partners Inc., Chicago.
Mr. Kaplan is vice president and chief economist at Ibbotson.
Well, it depends
How important is asset allocation?
"I think you have to say asset allocation is important, but how important it is depends on how important you think it should be," Mr. Ibbotson said in an interview.
At an Ibbotson Associates conference in Chicago last fall, Mr. Ibbotson remarked, "If you stick to your policy, asset allocation is important. If you don't stick to your policy, asset allocation is not important."
Messrs. Ibbotson and Kaplan note in their study that "the Brinson studies are often misinterpreted and the results are applied to questions that the study never intended to answer."
The Brinson studies don't address two important questions, they write:
How important is asset allocation in explaining the variation of performance between funds?
* What portion of the level of a typical fund's return is due to asset allocation policy?
Because the Brinson studies do not address these questions, "you can neither look to them to find the answer nor fault them for not answering" the questions correctly, Messrs. Ibbotson and Kaplan write.
Controversy about the importance of asset allocation comes from treating the answer the Brinson studies provided to the original question -- how much of the variation in returns is explained by asset allocation -- to the two other questions.
Messrs. Ibbotson and Kaplan, in their study, attempt to answer the two new questions, while re-examining the Brinson studies' original question. They also looked at balanced mutual funds, as well as pension funds, while the Brinson studies looked only at pension funds.
The new study confirms indeed about "90% of the variability of a fund's return across time is explained by the variability of policy returns."
Fluctuations explained
In other words, Mr. Ibbotson said in the interview, for pension funds, "there will be a lot of fluctuations in returns, but the policy benchmark will explain some 90% of the fluctuations in return."
In answer to their two new questions, Messrs. Ibbotson and Kaplan found:
* "About 40% of the variation of returns across funds is explained by policy."
* "About 100% of the return level is explained by the policy return."
Two other components make up a fund's investment return: decisions on market timing and decisions on the selection of active managers or active security selections.
The Brinson group shows "that strategic asset allocation explains so much of the variability of pension fund returns because plan sponsors select a long-term strategic target and tend to stick to it," according to the Ibbotson-Kaplan analysis. "If plan sponsors were more active, the R-squareds would be lower," meaning the proportion of return explained by asset allocation would fall below 90%.
While essentially confirming the result for pension funds of the original Brinson study, the Ibbotson-Kaplan study found that for mutual funds, the explanation averaged 87.6%.
Mutual funds take bets
And for both pension funds and mutual funds, the explanatory power of allocation had a wider range. For pension funds, it ranged from 66.2% to 97.2%. For mutual funds, it ranged from 46.9% to 94.1%, according to the new study.
Mutual funds "are more willing to make timing and selection bets against the benchmark," they write, explaining the greater range for them.
Examining the question of how much of the variation of returns across funds is explained by differences in policy, the Ibbotson-Kaplan study found:
* For mutual funds, 40% of the return difference was explained by policy. The remaining 60% of return was explained by other factors, such as asset-class timing, style within asset classes and security selection.
* For pension funds, it was 35%. The other 65% of return is explained by the same factors as for mutual funds and also manager selection.
Timing and active selection (whether manager selection or security selection) "have a bigger impact in comparing funds" than has policy asset allocation, Mr. Ibbotson said.
Calculations
Looking at the question of what portion of the return level is explained by the policy return, Messrs. Ibbotson and Kaplan calculate it as the ratio of compound annual policy return divided by the compound annual total return.
So a fund "that stayed exactly at its policy mix and invested passively will have a ratio of 1 or 100%, while a fund that outperformed its policy will have a ratio of less than one," they write.
"On average, policy accounts for a little more than all of total return."
Messrs. Ibbotson and Kaplan conclude:
"This means that on average the pension funds and balanced mutual funds are not adding value above their policy due to their combination of timing, security selection, and management and fees and expenses."
Results for both pension funds and mutual funds might be even better than policy, they write, because they might have some benefit from not rebalancing, that is, letting their equity allocation grow, during the almost continuous 18-year-long U.S. bull market. By not rebalancing, the funds are making a market-timing decision, Mr. Ibbotson remarked at the conference.
At the Chicago conference, Mr. Ibbotson said, "I don't think it's bad that pension funds aren't doing a lot of active asset allocation. The evidence shows it doesn't work."
"Pension funds don't change much," he added. "They follow the policy." To conclude such a larger percentage of pension fund return is explained by policy, he said, "It's more of a statement of fact rather than a grand truth."
"The more active you are, the lower your R-squared. The R-squared measures your conviction, your willingness to be active," he said.
"Active return depends on your conviction and ability to time and select. If you're not going to be active, you're not going to differ much from policy return."
"We're not making a grand statement that active management doesn't work," he added. "It doesn't work on average. But it works in some cases.
"We're not testing active management. We're testing how much return comes from policy."
