Two recent, separate studies re-examine the significance of asset allocation on performance. Or, in other words, they ask, "What is the importance of investment policy?"
Between the two studies there is significant disagreement about what matters and how to write it up. One of the two studies looks like scatter shot, while the other comes up with a single answer.
Why the difference?
In a March 8 Pensions & Investments news story, Barry B. Burr reported on one of the studies, one by Roger Ibbotson and Paul Kaplan of Ibbotson Associates Inc.
What Mr. Burr didn't know is that I am the architect of both studies, the one prepared by Messrs. Ibbotson and Kaplan on mutual funds and the other by Dale Stevens of Wurts & Associates Inc. on pension plans.
Nor did he know Mr. Ibbotson and I agreed to disagree on how the results of these studies should be described to investors. Our agreement is that two articles will be published in journals.
The Ibbotson-Kaplan article examines the questions that could be asked on investment policy.
The article I co-authored with Mr. Stevens and Mark Wimer of Ibbotson Associates attempts to answer the one question that I believe is being asked.
Let me tell you the difference.
I believe the real question is: How important is investment policy to investor wealth?
The other question that could be asked is: How much of the volatility in wealth is explained by investment policy? This alternative, and I believe less meaningful, question is the one addressed in the famous 1986 study "Determinants of Portfolio Performance" by Gary P. Brinson, Randolph Hood and Gilbert L. Beebower. The Brinson answer is more than 90%. The volatility question is answered by using a statistic called R-squared, a measure of correlation.
If you ask the volatility question in a slightly different way you get this 90% down to 40%, which is one of the answers in the Ibbotson-Kaplan study.
The answer to the $64,000 question, that is, what I think is the real question (drum roll): Investment policy is responsible for about 100% of investor terminal wealth.
I think investors, instead of asking about asset allocation's impact on volatility or variability, are really asking how much of their wealth is tied to investment policy vs. the other sources of growth, namely, manager selection or security selection and timing.
The Brinson study and most aspects of the Ibbotson-Kaplan article measure the influence of asset allocation on performance by using R-squared. But R-squared doesn't explain anything of importance in my opinion -- it measures the percentage of volatility explained by policy.
Let's take an example of two funds.
One fund has good selection and timing, and earns a premium above its policy return.
The other fund has poor performance.
Both have an R-squared of 0.95%, which could be interpreted erroneously to mean 95% of their performance is explained by asset allocation.
But a better way of measuring the power of asset allocation on performance is by a ratio, taking a fund's policy return divided by its actual total return.
Using this method, for the outperforming fund we could get, for example, a 0.6 ratio, implying 60% of this fund's return is attributable to policy, with the balance attributable to good stock selection and timing.
For the underperforming fund, we could get a ratio of 1.4, implying 140% of this fund's return is explained by policy, with the difference between this and 100% explained by poor stock selection and poor timing.
For the average fund, policy explains about 100% of ending wealth. That is, the ratio of policy return to actual return is roughly 1.0 for the average fund. This is the conclusion of all of the studies that ask the question "What percentage of ending wealth is attributable to investment policy?"
Investors should read asset allocation articles carefully to determine the question that is being posed.
If the question pertains to volatility, recognize that it is focused on the zigs and zags of wealth. I believe the more pertinent studies focus on where these zigs and zags end up: how much moolah you have at the end of the day.
Ronald J. Surz is managing director of Roxbury Capital Management Inc., Santa Monica, Calif.
