Ever since Gary Brinson, Randolph Hood and Gil Beebower published their seminal paper in 1986 on the importance of asset allocation in investing, there has been confusion and some heated debate over the correct answer to the question: Does asset allocation explain 40%, 90% or 100% of investment performance?
Different experts give different answers; but if you were reading Pensions & Investments a year ago, you know the correct one. According to Roger C. Ibbotson, chairman of Ibbotson Associates Inc., Chicago, and Paul D. Kaplan, director of the Morningstar Center for Quantitative Research, Chicago, the correct answer is: All of the above, depending on how you ask the question.
Their full analysis appeared in the January/February issue of the Financial Analysts Journal. P&I reported on the research last March, but still confusion reigns. In an interview this month, Mr. Ibbotson explained that the quandary over the contribution of asset allocation to returns occurs because people, although they think they are asking the same question in different ways, are really asking three different questions.
The first question is: What part of the return, the amount, is explained by asset allocation?
The second question is: How much of the variation of returns across funds is explained by differences in asset allocation?
And the third question is: How much of the variability of returns across time is explained by asset allocation?
Messrs. Ibbotson and Kaplan set out to answer all three questions, examining returns and asset allocation using 94 balanced mutual funds and 58 pension funds.
The problem has been, Mr. Ibbotson said, that investors often interpret the Brinson, Hood, Beebower paper as saying the answer to the first question is 90%. This is incorrect, he said. The correct answer is that, on average, about 100% of the return amount is explained by asset allocation policy.
"This is so because, on average, active management adds nothing," Mr. Ibbotson said. "This does not say you should not use active management. We are talking about averages, and on average active management adds nothing."
The more interesting question, he said, is the second question. "That is, suppose over 10 years one sponsor's fund has a return of 15% a year and another has a return of 25%," Mr. Ibbotson said. "Why are they different? We found 40% of the return difference is explained by different asset allocations."
That's really the important question because funds are compared with other funds, and sponsors want to know why their results are different, Mr. Ibbotson said. "The answer is that 40% of the difference is because of the different mix of stocks, bonds, cash, etc. The rest has to do with things like which managers you have, which stocks, timing decisions and fee levels, etc."
The Brinson, Hood, Beebower paper answered, in fact, the third question. There the answer is 90%, Mr. Ibbotson said. That is, about 90% of the variations in a fund's returns from year to year is due to the fluctuations in returns in the fund's underlying asset classes -- its asset allocation.
This research should prompt reviews on the importance of asset allocation to investment returns, including reviews of 401(k) educational programs to make sure they are not misstating the research and, so, misleading individual investors.
Now we hope that has cleared up the confusion. But one more question: What percentage of you think it has? 100%? 90%? 40%?