Talking asset allocation – don’t get misquoted

June 11, 2014 Categories: Investment Strategy
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Some of the most famous quotations are actually misquotations. Avid fans of Humphrey Bogart know that he never actually said: “play it again Sam” in his scenes with Ingrid Bergman.

Greta Garbo didn’t really say: “I want to be alone” – instead she wanted to be “let alone”. And there is no evidence at all to support the popular belief that Napoleon declined Josephine’s amorous offer with the reply: “Not tonight…” In the less popular world of asset allocation studies, life is not quite so glamorous but is fraught with the same misunderstandings. In 1986, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower (BHB) published a study about asset allocation of 91 large pension funds, and concluded that, so far as volatility was concerned, asset allocation determined 90% of the variation in returns from an investment portfolio. This study – and others that followed – have been widely misinterpreted, giving rise to the belief that 90% of all investment returns are driven by asset allocation. By extension, investors have been led to misunderstand and underrate the potential contribution of active management. Let’s a look at the sample portfolio below to see where the risk and return really come from. wire-blog-portfolio-graph1 (1) So the chart speaks unambiguously to the following three points:

  1. Active management has a low correlation to markets: it may do well as markets decline, or conversely it may underperform as markets do well. As such, market risk and active-management risk do not simply add together.
  2. Asset allocation will always dominate the volatility of returns. Adding active management may add little variation in total return, although it may introduce other risks (for example illiquidity and greater operational risk).
  3. By contrast, the returns from the market and from active management do simply add together. Successful active management can add a meaningful proportion of return, especially in low-returning markets.

So if we’re talking asset allocation, it’s important to be clear about the distinction between returns and volatility, and to recognise the potential benefits of non-correlated sources of return such as active management.

One further thought (if you like a bit of maths!)

The mathematics of the sample portfolio example used is made convenient by choosing positive returns for both asset allocation and active management. But if one is positive, and the other negative, it’s a little trickier… What would you say if the return from asset allocation were -4.8%, and the return from active management was +1%? Or if the return from asset allocation were +4.8% and from active management -1%? Because we are trying to average dissimilar outcomes, the phrase ‘explains over 90% of the returns’ does not actually mean very much. By contrast, ’90% of the variation in returns’ is meaningful, as the standard measure of variation is always positive. 10 Second Myth Buster: Myth Asset allocation explains over 90% of the returns from an investment portfolio. Reality Asset allocation explains over 90% of the variation in returns–or the risk–from an investment portfolio.

* Russell, based on capital market assumptions as at 31 December 2013, 10-year forecast horizon. Assuming a tracking error of 4% and that active management return is not correlated to market return, i.e. that the added return from active management is -4% and +4% two thirds of the time, and whether it is positive or negative does not depend on whether the market return is positive or negative. For illustrative purposes only.

  Sorca Kelly-Scholte – Managing Director, Client Strategies & Research, EMEA Sorca Kelly-Scholte

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