| Richard
Newell
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Every
so often an academic study comes along that changes the way
we think about investing. One such study, published in 1986
by Gary Brinson, L. Randolph Hood and Gilbert Beebower, taught
us that asset allocation, rather than stock picking or market
timing, is by far the most important factor that determines
the returns that a portfolio will generate over time.
A further study published in 1999 extended the prior findings,
while seeking to correct some misinterpretations of the earlier
work. Asset allocation really is the driving force behind portfolio
performance, but active managers can make a difference. Note
the word "can". While some managers do add value,
the report says, on average they do not - and probably never
will.
The study's authors are Roger Ibbotson, the Yale finance professor
and chairman of Ibbotson Associates, whose data on historic
market performance is the foundation for much of today's portfolio
management industry, and Paul Kaplan, vice president and chief
economist at Ibbotson Associates. (You can download the study,
entitled "Does Asset Allocation Policy Explain 40%, 90%,
or 100% of Performance?" at www.ibbotson.com.)
The Ibbotson/Kaplan report builds on the 1986 work of Brinson,
Hood and Beebower, who studied the performance of 91 large U.S.
pension plans between 1974 and 1983. (Brinson, Beebower and
Brian Singer published a follow-up study in 1991 that essentially
confirmed the results of their first paper. Both studies were
published in the Financial Analysts Journal.) The 1986 and
1991 studies concluded that, on average, asset allocation explains
more than 90% of the quarterly variation in a given portfolio's
returns.
Over the years the Brinson report has taken on the aura of Gospel
in the investment community, but Ibbotson says it is widely
misunderstood. The Brinson group sought to explain what factors
made a given portfolio's returns better or worse in a particular
quarter. Brinson did not seek to explain why Portfolio A might
outperform Portfolio B. This is one of the tasks Ibbotson and
Kaplan set out to accomplish.
First, they replicated Brinson's results with two new sets of
data. Ibbotson/Kaplan looked at 10 years of monthly returns
for 94 balanced (i.e., stock and bond) mutual funds and 10 years
of quarterly returns for 58 pension funds. They confirmed Brinson's
finding that asset allocation explains about 90% of the period-to-period
variability of a portfolio.
Next, they compared each fund's returns to those of the other
funds to determine how much of the difference between funds
could be explained by asset allocation policy. If each fund
was invested passively (as in a combination of index funds)
with the same asset allocation, there would be no variation
at all between funds. On the other hand, if each fund was invested
passively but with different asset allocations, all of the inter-fund
variation would be due to asset allocation, since there would
be no active management.
The Ibbotson/Kaplan study finds that only about 40% of the variation
between funds is derived from differences in asset allocation.
The remaining 60% of fund performance variation results from
such other factors as the timing of moves between asset classes,
security style (e.g. value or growth stock) within asset
classes, security selection, and expenses.
This is no great shock, when we reflect on it. If we compare
an actively managed, large-capitalization U.S. stock fund to
a Standard & Poor's 500 index fund, we would expect to see
differences in performance arising from the success or lack
thereof of the active manager's moves and from the higher expenses
that accompany active management. Still, we would expect in
most periods to see these two funds' returns be closer to each
other's level than to, say, the three-month Treasury bill rate.
Factors other than asset allocation may account for most of
the difference between funds, but the differences between funds
in a given asset class are, we would expect, typically much
smaller than the differences between asset classes. Unfortunately,
the Ibbotson/Kaplan study does not give us the details we need
to confirm this assumption.
Finally, Ibbotson and Kaplan tell us that asset allocation ultimately
accounts for all of the absolute level of performance of the
portfolios they studied - on average. In fact, the average fund
performs slightly below the level one would expect for its asset
allocation. This is because the average of all investors is
the market itself, so the good managers and the bad tend to
cancel each other out before expenses are considered. Since
expenses do not net out across investors, the average return
in a portfolio is pushed below the average return for the market.
What practical guidance can we draw from the Ibbotson/Kaplan
work?
- Asset allocation
is still the unquestioned driver of portfolio performance.
Since effective and ineffective managers cancel each other
out in the marketplace, asset allocation - taking advantage
of the fact that the markets tend to go up over time - is
the only reason the average investor makes any money investing.
- Active managers
can earn their keep if you know how to pick the good ones.
Unfortunately, Ibbotson/Kaplan offer no help on this score
other than citing another study suggesting that hot managers
tend to stay hot and cold managers cold. I lean more toward
the theory that in the most closely followed and efficient
markets, such as for major American companies, it is nearly
impossible for any active manager to be a consistent winner.
This is why index funds continue to look so good. If you
are in any doubt, seek out active managers in smaller, less
liquid or niche marketplaces and use indexes for the big
stocks.
- No investment strategy
can help if you sit on the sidelines. A big part of effective
investing is in the fundamental work of getting cash invested
quickly, keeping your asset allocation at the desired balance,
and knowing your own risk tolerance so you can resist the
temptation to bail out at the first sign of turbulence.
If you would
like to know more, please send
me an e-mail. |
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| Copyright 2003-2007
Richard Newell. All rights reserved. |
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