When Active Management Matters

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Financial planners have eagerly awaited any research that could finally, definitively prove – or disprove – the pesky notion that active management is effective. Though no one has yet risen to that challenge, past academic studies have been improperly interpreted to show that portfolio policy, or asset allocation affects portfolio returns far more than active management. 

The most recent study to tackle the active management debate, by Yale professor Roger Ibbotson, shares two weaknesses with previous research. As a result, its methodology masks the value of actively managing a fund’s asset allocation and consequently it fails to reward “eclectic,” unconstrained active managers.

Before exploring those weaknesses, we will summarize the previous research on this topic, and once we’ve finished we will conclude with the lessons this research holds for financial advisors.

Background: Research on the roles of active management and asset allocation

Perhaps the best known study on the subject of active management and asset allocation was by The Determinants of Portfolio Performance, by Brinson, Hood, and Beebower (BHB), published in 1986.  That study was misinterpreted by the industry to say that 93.6% of portfolio return is determined by asset allocation policy when the study actually concluded that 93.6% of portfolio volatility is determined by portfolio policy.  Many key conclusions of the study were subsequently refuted by William Jahnke in his paper, The Asset Allocation Hoax, which Jahnke published in February of 1997. 

Most recently, Roger Ibbottson has published two papers on the subject in the March/April issue of Financial Analysts Journal: The Importance of Active Management and The Equal Importance of Asset Allocation and Active Management.  The latter article was coauthored by James Xiong, Thomas Idzorek, and Peng Chen.  The papers attempt to take a fresh look at the impact of active management (and other factors) on fund performance, and in the process it addresses criticisms of the original BHB study.

Unfortunately, we believe that Ibbotson’s conclusions have limited application, because the study is based on a universe of managers who are severely constrained in their capacity to be “active.”  In addition, Ibbotson’s methodology may minimize the apparent impact of active management when managers are “significantly” active in their portfolio allocations.  Accordingly, it implies an erroneous conclusion that all forms of active management have a relatively small impact on portfolio returns.

Ibbottson and his coauthors assume three factors explain the variation in portfolio returns: market returns, the excess returns from asset allocation policy, and the excess returns from active management.  The authors study the performance of 4,641 U.S. equity funds, 587 balanced funds, and 400 international equity mutual funds in the Morningstar database from May of 1999 to April of 2009. They initially conclude that market returns have a disproportionately large impact on portfolio returns – more than 80% of returns are attributable to market movements alone, they found.  They then removed the impact of market returns (a change from prior studies) and determined that portfolio policy and active management have a roughly equal impact on determining any remaining excess returns over and above the market’s returns.