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Asset Allocation Theory
Asset Allocation Concept

Asset allocation aims to balance risk versus reward forming the core to many investment strategies. Often cited maxim is that asset allocation determines 90% of your return. Unfortunately, this maxim is more urban legend than truth, based on misinterpretation of research.

One can make an argument that strategic asset allocation is one of the cardinal steps in the portfolio construction process; many would believe the most important decision. This step determines the proportion of a fund that should be exposed to an asset class that changes in value. 

  • This exposure can be positive or negative
  • This can be an active decision to choose asset classes that in theory will outperform over a certain time horizon
  • It offers the first version of diversification, regardless of whether the strategy is active or passive
  • Traditional View on Asset Classes
  • Capital Assets
  • Consumable or Transformable
  • Store of Value Assets
  • Human Capital
  • Reference or Additional Material
Typical Allocation of Average Investor Products

A better way would be to think of three super asset classes as suggested

Chart 1 Typical Allocation of a Balance Fund

How much of your return is dependant on Asset Allocation? 
It is now a day assumed by most finance professionals that asset allocation explains around 90% of a funds return. Unfortunately, this industry assumption is because of the misinterpretation of a 1986 study “Determinants of Portfolio Performance” (Brinson, et al., 1986). 

The study examined the quarterly returns of 91 large USA pension funds from 1974 to 1983, comparing the returns to those of a theoretical fund invested in indices with the same average asset allocation. A regression analysis found a R-Squared of 93.6%, which suggested that asset allocation explains 93.6% of the variation in a portfolio’s returns.

In 1991 an update study (Brinson, et al., 1991) was done to cover the years from 1977 to 1987 and the regression analysis found a 91.5% R-Squared. An article titled “Setting the Record Straight on Asset Allocation” (Larrabee, 2012) published on the CFA Institute website gives a detailed overview on the evolution of the argument around this somewhat controversial topic, the key points of which are touched on below.

The industry misquoted the results by inferring that the asset allocation decision you make results in over 90% of your return, while the original finding instead related to only to an explanation of the variability of the return.

Subsequently, in a study aimed at addressing the controversy (Ibbotson & Kaplan, 2000) the authors looked at 10 years of monthly returns for 94 balanced mutual funds and 10 years of quarterly returns for 58 pension funds. The aim of the study was to answer 3 questions:

  • How much of variability returns cross time is explained by asset allocation policy?
  • How much of the variation in returns among funds is explained by differences in asset allocation policy?
  • What portion of the return level is explained by policy return?

The results regarding the first question confirmed the original Brinson study finding that asset allocation policy explains about 90% of the period-to-period variability of a fund. 

An interesting point made by these authors was that the high R-Squared is explained by the funds’ exposure to the capital markets as a common factor. To quote these authors: “a case of a rising tide lifting all boats.”
Regarding the second question, they found that only about 40% of the return variation between funds is because of asset allocation, with the balance being because of other factors:

  • including asset-class timing
  • style within asset classes
  • security selection
  • fees.
Three Components of a Funds Return

The third question was more elegantly answered in a paper “The Importance of Asset Allocation” (Ibbotson, 2010) also by Roger Ibbotson. The argument he made is that the total return of a fund can be split into three parts:

  • Return based on the overall market movement
  • The incremental return from the asset allocation policy
  • The active return, such as market timing, selection and fees

He found that about 75% of the variation in time series returns comes from general market movement. With the remaining variation, split equally between asset allocation policy and active management.

It is therefore clear that the asset allocation is not the alpha and omega that we see it as in the industry at present. The traditional view of asset allocation is not diversified enough regarding the underlying driving factors of returns.

Reference/Additional Material

Determinants of Portfolio Performance
Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower
Financial Analysts Journal
Vol. 42, No. 4 (Jul. - Aug., 1986), pp. 39-44

Setting the Record Straight on Asset Allocation
David Larrabee, CFA

Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?
Roger G. IbbotsonPaul D. Kaplan

The Importance of Asset Allocation
Roger G. Ibbotson
Financial Analysts Journal
Vol. 66, No. 2 (March/April 2010), pp. 18-20