The mutual fund in-dustry has been telling financial advisors for years that asset allocation is the most important investment decision. At the same time, the industry tries to make the case for its actively managed investment funds. Ironically, these are inconsistent messages that are rarely, if ever, challenged. So, before letting this asset-allocation argument roll off of your tongue, you may want to take a step back and consider a few key points.
A fund company, when promoting its funds, usually describes the “unique” style of its money managers and the list of associated benefits. In so doing, the firm is essentially trying to demonstrate why a chosen manager is better than a competitor’s for a given slice of client portfolios. This is essentially making the case for “security selection” in the broader context of investment decisions to be made.
The other, admittedly bigger, decision is investment strategy — or asset mix. A paper entitled “Determinants of Portfolio Performance,” by Gary Brinson et al, in the July/August 1986 issue of Financial Analysts Journal set the stage for the industry to start beating its drum. That paper — and subsequent revisions — found that north of 90% of the quarterly variance in pension fund returns was explained by asset mix alone.
The notion that asset mix is the most important portfolio decision, if you buy that, essentially commoditizes the individual securities. In other words, if broad asset mix decisions are what really matter, then there is no point spending the time trying to find the best Canadian equities manager. But, by emphasizing both, the industry tries to have its cake and eat it, too.
To make some sense of this, it may help to understand the context of past research and the reason why asset mix is so important.
Although the Brinson study focused on the impact of variability of return — not the absolute level of returns — it is generally accepted that asset mix has a large influence on the level of returns from year to year. But it may be useful to understand why.
Suppose you had to decide whether to allocate your portfolio either to U.S. bonds or to U.S. stocks in 2008. In that memorable year, U.S. bonds gained by about 5% while U.S. stocks dropped by a painful 37% (in U.S. dollars). Given those figures, it seems intuitive that asset mix would affect the level of returns, not just the variability thereof. But, ultimately, the impact of asset mix on your returns depends on your style of investing.
In the most extreme example, if you had put all of your money in U.S. stocks, but then concentrated it in the obscure Emergent BioSolutions Inc., you’d have ended 2008 with a return of 416%. The more concentrated your investing style, the less correlated your performance is likely to be with the broader index. Accordingly, asset mix matters relatively little.
The reality is that nobody invests like this. Quite justifiably, we all preach the notion of prudent diversification. The broader the diversification, the more highly correlated the portfolio’s performance will be with the index. And the closer you get to that point, the more important asset mix will be on both the volatility and the level of returns.
A decade ago, Roger Ibbotson and Paul Kaplan published a paper, also in the Financial Analysts Journal, entitled “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?” This excellent paper extends the research of Brinson et al. In short, they found that the importance of asset mix depends not only on whether you look at short- or long-term returns but also whether you are comparing funds against each other or against some risk-free default alternative.
For financial advisors who employ a very active style of investing, the differences in index returns may not matter much. But for the rest, who practise traditional, diversified portfolio construction, asset mix remains important for both the variability and the level of total returns. IE
Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for advisors, affluent families and institutions.