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Asset Allocation

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By Thomas M. Idzorek

movement, asset allocation and active management are equally

important in explaining return variations.

The importance of asset allocation has been

the subject of considerable debate and

misunderstanding for decades. What seems

like an easy question or topic on the surface is

actually quite complicated and filled with

nuance. In the recent article I wrote with my

fellow Ibbotson Associates James Xiong,

Roger Ibbotson, and Peng Chen, The Equal

Importance of Asset Allocation and Active

Management (published in the March/April

issue of Financial Analysts Journal), we

pinpoint one of the primary sources of

confusion surrounding the importance of asset

of our new paper, lets briefly recap the debate

and put our new contribution into context.

BHB Starts the Debate

allocation, the catalyst of a 25-year debate,

and unfortunately the source of what is

arguably the most prolific misunderstanding

among investment professionals, is the 1986

article Determinants of Portfolio Performance,

by Gary Brinson, Randolph Hood, and Gilbert

Beebower (BHB). BHB regressed the time

combination of indexes reflecting each funds

asset-allocation policy. In one of the many

analyses that BHB carried out (and probably

one of the least important ones), they found

that the policy mix explained 93.6% of the

average funds return variation over time (as

measured by the R-squared of the

regression)the keyword being variation.

Unfortunately, this 93.6% has been widely

misinterpreted. Many practitioners incorrectly

believe the number means that 93.6% of a

10-year annualized return) comes from a funds

asset-allocation policy. Not true. The truth is

that in aggregate 100% of portfolio return

levels comes from asset-allocation policy.

return dispersion (green line) explains why researchers get different results

when gauging the relative importance of asset allocation.

Rolling Cross-Sectional Regression Results on U.S. Equity Funds

Monthly Dispersion

levels and return variations. In the big picture,

investors care far more about return levels than

they do return variation. The often-cited 93.6%

says nothing about return levels, even though

that is what so many practitioners mistakenly

believe. It is possible to have a high R-squared,

indicating that the return variations in the

asset-class factors did a good job of explaining

the return variations of the fund in question,

yet see the weighted-average composite

asset-allocation policy benchmark produce a

significantly different return level than the fund

in question. This is the case in BHBs study.

Despite the high average 93.6% R-squared of

their 91 separate time-series regressions, the

average geometric annualized return of the 91

funds in their sample was 9.01% versus

10.11% for the corresponding policy portfolios.

12%

seems to be stuck in everyones mind, 112%

(10.11% divided by 9.01%) of return levels in

the studys sample came from asset-allocation

policy. To put it bluntly, when it comes to

returns levels, asset allocation is king. In

aggregate, 100% of return levels come from

asset allocation before fees and somewhat

more after fees. This is a mathematical truth

that stems from the concept of an all-inclusive

market portfolio and the fact that active

management is a zero-sum game. This

fundamental truth is somewhat boring;

therefore, it is often lost in the debate, even

though it is by far the most important result.

Residual Error

Fund Dispersion

10

8

6

4

2

May99

Sep00

Jan02

May03

others to overperform? In contrast with the

100% number that stems from a mathematical

identity, the answer to this question is an

empirical one. This also brings us back to our

new article, The Equal Importance of Asset

Allocation and Active Management.

allocation among funds as it pertains to return

variations, researchers use cross-sectional

regression rather than a time-series regression.

For example, in Roger Ibbotson and Paul

Kaplans 2000 article, Does Asset Allocation

Policy Explain 40, 90, or 100 Percent of

Performance? the 40% number comes from

a cross-sectional regression, the 90% comes

from a time-series regression, and the 100%

comes from the ratio of realized policy return to

fund return. More recently, in a 2007 article,

Raman Vardharaj and Frank Fabozzi performed

a series of cross-sectional regressions in which

the ensuing R-squareds varied widely (a result

they inaccurately attribute mostly to style drift).

interesting question for most investorseven

if in the bigger picture of realized return levels

it is far less important. Among funds in a

particular peer group and over a time period,

investors misinterpreted the results of

cross-sectional regressions. Historically, these

cross-sectional regressions have been

Sep04

Jan06

May07

Sep08

some may have mistakenly interpreted the

R-squared as a statement about total returns

and the overall importance of asset allocation.

We show that a cross-sectional regression

performed on total returns is equivalent to a

cross-sectional regression performed on

market-excess returns, because the crosssectional regression procedure naturally

removes the common market return that is

inherent in the peer group of funds being

analyzed. I use the term market loosely to

describe the peer-group-specific common

return, but the results would not change

significantly with a more-generic market

definition. After we identify the inherent market

return as the weighted average return of the

funds being analyzed, we convert total returns

into market-excess returns by subtracting the

peer-group-specific market return. When one

performs a cross-sectional regression, it

doesnt matter which type of returns one

usestotal returns or excess-market returns.

The beta coefficient and R-squared from the

cross-sectional regressions are the same; only

the intercepts are different. This is proof that a

cross-sectional regression naturally removes

the common market factor and, more importantly, that the R-squared from a cross-section-

MorningstarAdvisor.com 29

Gray Matters

regression R-squareds is 40% (blue line), meaning that variations in asset

allocation explain approximately 40% of excess-market return variations.

movement of the market, detailed assetallocation decisions and active management

are about equally important, although this

result varies significantly over time.

R^2

R^2

Average

100%

80

60

40

20

May99

Sep00

Jan02

May03

Sep04

Jan06

May07

Sep08

overall importance of asset allocation.

Why Results May Vary

40% number associated with cross-sectional

analysis, our article makes two additional

important contributions.

First, by running a series of rolling cross-sectional regression analyses (in which the return

of each fund in question is regressed against

its corresponding asset allocation policy) and

graphing the residual error, the cross-sectional

fund return dispersion, and the resulting

R-squared at each point in time, we pinpoint

that dramatic changes over time in crosssectional fund return dispersion explain why

different researchers may get very different

cross-sectional results. Most researchers have

simply run one cross-sectional regression and

present the corresponding regression results,

rather than a series of cross-sectional

regressions results. In Exhibit 1, we link each of

these separate cross-sectional regession

results. The green line represents the

cross-sectional fund return dispersion at each

line represents the standard deviation in the

unexplained residual returns. Taking the

information in Exhibit 1 and recalling that the

formula for R-squared is 1 minus the variance

in the unexplained residual returns divided by

the cross-sectional fund return variance, we

plot the rolling cross-sectional regression

R-squareds in Exhibit 2. The average of the

rolling regressions is around 40% (blue line),

indicating that variations in asset allocation in

excess of market movement explain 40% of the

excess-market return variations.

Next, in Exhibit 3, by performing a time-series

analysis on excess-market returns, we put

time-series regression analysis and crosssectional regression analysis on an even

playing field for the first time. The R-squareds

from a time-series regression on excess-market

returns and cross-sectional regression on either

type of return (total or excess-market) give us

consistent answers. The frequency in the

vertical axis is rescaled for 4,641 time-series

regressions and 120 cross-sectional regressions so that the cumulative distribution adds

up to 100% for both sets of regressions.

Market Movement

number that comes from a time-series

regression on total returns, some researchersespecially our own Roger Ibbotson

think that it is important to recognize that much

of the 90 percent in return variations comes

from the markets overall movement, while a

much smaller amount comes from the return

variations coming from the granular assetallocation decisions. This was an important

contribution from Ibbotson and Kaplan (2000)

that was largely overlooked, and it is a point

made even more clear by our new research.

The 90 percent number comes from a

time-series regression, typically on multiple

asset-class factors. Switching from a

somewhat granular list of asset-class factors to

a single explanatory variable, such as the S&P

500 (single factor regression), typically leads to

only a minor decrease in the average R-squared.

In Exhibit 4, the left two bars illustrate the BHB

time-series regression analysis for both equity

and balanced funds in which the bulk of the

return variations are attributed to what is

usually identified as asset-allocation policy. In

contrast, the right two bars illustrate the

arguments put forth in Hensel, Ezra, and Ilkiw

(1991) and Ibbotson and Kaplan (2000) (HEI &

IK)that market movement dominates

time-series regressions on total returns. The

two right bars give a more detailed decomposition of total return and its parts: the applicable

market return, asset-allocation policy return in

excess of the market return, and the return

from active portfolio management. Taken

together, market return and asset-allocation

return in excess of market return dominate

active portfolio management. This affirms that

market return plus asset-allocation return in

excess of market return are the dominant

determinants of total return variations.

regressions on equal footing, asset-allocation decisions in excess of

market movement and active management are about equally important at

explaining return variations.

Time Series and Cross-Sectional R-Squared Distributions

Frequency

Excess-Market Time-Series

Cross-Sectional

0.25

0.2

0.15

0.1

0.05

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

R^2

return variations to asset-allocation policy (left two bars). In contrast, HEI & IK

argue that market movement dominates (right two bars).

Decomposition of Total-Return Variations

Asset-Allocation Policy

Market Movement

Investment Strategy

Interaction Effect*

R-Squared

important, but the answer to the question of

how important is tricky. Unfortunately, BHBs

landmark article unintentionally created the

fallacy that 90% of return levels come from

asset allocation. Investors would do well to

forget the 90% number. In aggregate, 100% of

return levels come from asset allocation.

Return variations are dominated by the

common market factor embedded in the funds

being analyzed. After removing this common

market factor, on average for typical funds

about half of the return variations comes from

detailed asset-allocation decisions in excess of

the market movement and about half of the

return variations comes from active management, although this 50/50 result dramatically

changes from one period to the next. Our

research clarifies the contribution of each and

highlights the significant contribution from

market movement. For aggregate return levels,

asset allocation is king! K

Thomas M. Idzorek, CFA, is chief investment officer at

Ibbotson Associates, a Morningstar company.

References

Brinson, Gary P., L. Randolph Hood, and Gilbert L.

Beebower. 1986. Determinants of Portfolio

pp. 3944.

120%

100

The Importance of the Asset Allocation Decision.

Financial Analysts Journal, July/August, pp. 6572.

80

60

Allocation. Financial Analysts Journal, March/April.

40

20

Asset Allocation Policy Explain 40, 90, or 100 Percent

of Performance? Financial Analysts Journal, January/

February, pp. 2633.

0

20

BHB Equity Funds

Time-Series Regressions

Vardharaj, Raman and Frank J. Fabozzi. 2007. Sector,

Style, Region: Explaining Stock Allocation Performance,

Financial Analysts Journal, May/June, pp. 5970.

*The interaction effect is a balancing term that makes the three return components of R-squared add up to 100%.

Idzorek, and Peng Chen, 2010. The Equal Importance

Analysts Journal, March/April.

MorningstarAdvisor.com 31

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