Asset Allocation Matters, But Not as Much as You Think

We’re all familiar with the 1986 finding by Gary Brinson, Randolph Hood, and Gilbert Beebower (BHB) that asset allocation explains 93.6% of the average fund’s return variance over time.  Ironically, their findings also rank among the most misunderstood in the financial literature, but, even if correctly interpreted, their findings do not answer a key question for advisors: What role do market movements and active management play in explaining return variance?

Roger Ibbotson, the founder of Ibbotson Associates, has published new research showing that those two factors matter a lot more than asset allocation in explaining the variation of returns over time.  I spoke with Ibbotson last week about his research, which he published in two articles, The Importance of Asset Allocation and The Equal Importance of Asset Allocation and Active Management, both of which appeared in the March/April issue of the Financial Analysts Journal.  The latter article was co-authored by James Xiong, Thomas Idzorek and Peng Chen.

Ibbotson is an outside advisor to Morningstar, having sold his firm to them in 2006.  He is also a part-time professor at the Yale School of Management.  His primary role, however, is as chairman and chief investment officer of Zebra Capital.   Zebra recently introduced two mutual funds designed to capture the return premium associated with illiquid securities, and I also spoke with him about his research behind those funds.

BHB revisited

The BHB result came from regressing the time-series returns of a universe of funds over a ten-year period.  They compared each fund to a series of indices that reflected its policy mix.  The problem with this approach is that it did not distinguish whether the variation in returns (measured as the r-squared) was due to the policy mix (asset allocation) or to movements in the overall market; those two factors were lumped together in the 93.6% result.

Subsequent research, including a paper co-authored by Ibbotson and Morningstar’s Paul Kaplan in 2000, showed that most of the variation in returns owed to market movements.  Instead of a time-series approach, they used a cross-sectional approach, comparing the annual returns for a universe of balanced funds.  This approach neutralized the effect of market movements and showed that asset allocation explained approximately 40% of the variation across.  Other studies found this figure to be anywhere between 33% and 75%, depending on the universe of funds and the time period studied.

Ibbotson and his three co-authors dug deeper by using a time-series approach to separate the contributions of market movements and asset allocation.  Their findings are summarized in the following figure:

Decomp Time-Series

Each bar indicates how four factors explain the variation of returns: active management, asset allocation, market movements and an interaction effect.  BHB did not distinguish between asset allocation and market movement; instead they attributed all variation to asset allocation.  The more recent research, shown as the two bars on the right, shows the dominance of market movements in explaining the variation of returns, once they have been disentangled from asset allocation.