Impact of market movements plumbed in new study

Market movements trump asset allocation as well as active management, according to new research from Ibbotson Associates Inc. that was just published in the Financial Analysts Journal.

In fact, the decision to be invested in risky assets, that is, equities — referred to as market movements — is responsible for 75% of the variations in investor returns, the new study from Ibbotson researchers found. Asset allocation policy and active management each account for only 12.5% of portfolio return variation.

The new article, “The Equal Importance of Asset Allocation and Active Management,” draws a somewhat “similar conclusion” in re-examining the seminal findings of a 25-year-old study on the importance of asset allocation, said Thomas M. Idzorek, Ibbotson chief investment officer and director of research and co-author of the new study.

“It is a trickier and more nuanced issue than people realize,” Mr. Idzorek said about explaining the importance of asset allocation and variation in return.

That influential study, “Determinants of Portfolio Performance,” by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, published in the July/August 1986 Financial Analysts Journal, found that asset allocation policy mix explains 93.6% of the average pension fund's return variation over time. In turn, it found active management accounted for the rest of the variation, less than 7%.

That study, however, has been widely misinterpreted among investment professionals since it was published, said Mr. Idzorek. Many investment professionals misinterpret the results to mean a fund's return level comes almost all from asset allocation policy, Mr. Idzorek said.

Asset allocation, in fact, on average “drives 100% of the level of aggregate returns,” he said, a number determined by another study and confirming somewhat the misinterpretation.

“But the real level is 100%,” Mr. Idzorek said, not 93.6%. “I don't want to say this misinterpretation is right.” Practitioners “misinterpreting asset allocation believe it accounts for about 90% of the level” of return.

“Asset allocation is king ultimately when you talk about return levels,” he said. “One hundred percent of return level comes from asset allocation policy on average. ... In aggregate, active management is a zero-sum game.”

“It's extremely important to differentiate between return level and return variation,” he added. “That's where our new study makes a new contribution” to explaining the variation of return.

The latest study was done by Mr. Idzorek, James X. Xiong, Peng Chen and Roger Ibbotson. Mr. Xiong is a senior research consultant with, and Mr. Chen, president of, Ibbotson Associates, a unit of Morningstar Inc., Chicago.

Mr. Ibbotson is chairman and chief investment officer of Zebra Capital Management LLC, Milford, Conn; professor in the practice of management, Yale University School of Management, New Haven, Conn; and founder and adviser to Ibbotson Associates.

The Brinson-Hood-Beebower work divided returns into two components: asset allocation and active management. The new study “is a direct recognition that market movements dominate variation in return,” Mr. Idzorek said. “The Brinson study didn't break out market movements,” but included it in the asset allocation component. The new study breaks out market movements and recognizes the market is causing most of the variations in returns, Mr. Idzorek said. The new component led to the new conclusion.

The four authors split portfolio return into three elements: market return, asset allocation policy return in excess of the market return, and the return of active portfolio management.

The authors clarify the contribution of each component, with market movement having the dominant influence in return variation.

“Taken together, market return and asset allocation policy return in excess of market return dominate active portfolio management,” the authors wrote in their FAJ article.

“This finding confirms the widely held belief that market return and asset allocation policy return in excess of market return are collectively the dominant determinant of total return variations, but it clarifies the contribution of each,” the article said.

The study confirms findings of a study by Mr. Ibbotson and Paul D. Kaplan, quantitative research director of Morningstar's European business, reported in 1999 by Pensions & Investments. That study pointed out that the explanation in the variation in return “is dominated by market movements embedded in the total returns,” according to the new article by the four researchers. That study also found asset allocation determines 100% of return level.

By splitting out the market movement component, “we are able to pinpoint (better) the source of the (variations) over time,” Mr. Idzorek said. “The market movement factor (represents) how much you want in equities,” he added.

“That is the most important decision an investor will ever make, how much they want to participate in the (equity) market and that decision will determine their return level over time,” Mr. Idzorek said.

Asset allocation beyond market movements into other classes and subclasses explains only 12.5% of the variation in performance, the study noted. “Asset allocation is very important but nowhere near 90% of the variation in returns caused by the specific asset allocation mix,” Mr. Ibbotson wrote in an accompanying article to the March/April 2010 FAJ story.

“Only if we count (market movement) as part of asset allocation policy would (Brinson Hood Beebower) give use the appropriate answer,” Mr. Ibbotson wrote.

Mr. Idzorek said, “When you decide how much market movement you want to participate in, that's the big decision” of plan sponsors or other investors.

As for active management, finding managers who can add alpha over the long term is hard to do, he said. Active management in general hasn't beaten the market in the long run.

“Outperforming the market is tough,” Mr. Idzorek said. There is “very little evidence of persistence” in performance of active managers.