June 15, 2010
The role of active management
Another way to understand the contributors to return variance, Ibbotson said, is to consider a four-step process that looks like this: You begin by assuming you start with cash, then you go to an average asset mix, and then you go to the specific policy mix for a particular fund. Finally, you put in active management, which consists of actively managing your asset allocation plus actively managing your stock and bond selection, security selection, and of course paying some fees.
“Just going from cash to that average asset mix explains approximately 70% of the variation of returns,” Ibbotson said, although in the BHB study it was a little more than that. When you go to the next piece, which is the policy piece, it explains another 15% or so. The last piece, active management, explains the remaining 15% in the variation of returns.
The BHB study combined the first two steps to arrive at its 93.6% figure. Ibbotson said that the results from all these studies are sensitive to the universe of funds and the time period used in the study, which explains the differences between the BHB results and his own.
The key insight in Ibbotson’s latest research that a cross-sectional approach automatically eliminates market effect, because one just picks up the differences between funds. Over time, if you don't take the market effect out, you get the BHB results. His approach, using a time-series analysis, allows the variation in returns to be decomposed into how your policy mix and active management differ from the market.
Implications for advisors
As an advisor, a key question you must ask is which of your decisions will have the greatest impact on portfolio performance. On this score, Ibbotson’s research supports what most would consider intuitively obvious – one’s decision to be in or out of the market, versus being in cash, dominates. On average, that decision explains approximately 70% of the variation in portfolio returns, with the remaining 30% split roughly evenly between active management and asset allocation.
However, as Ibbotson and other researchers have cautioned, that result does not answer a key question that advisors often ask: How much of the level in returns in their portfolio does asset allocation explain? The answer, which Ibbotson called “trivial,” is that asset allocation explains the passive (beta) component of return and active management explains the active (alpha) portion.
Most advisors, Ibbotson said, have already made the decision to be in the market, and what they really control is the last two steps in the four-step process: the specific asset allocation and the degree of active management. Based on their clients’ age, risk preferences, and other factors, advisors determine an appropriate asset allocation and active/passive strategy. “Now you know how important asset allocation and active management are in affecting the answer,” Ibbotson said.
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