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Retirement Perspectives

Recent research debunks the idea that asset allocation accounts for 90% of portfolio performance, and shows that active management—especially stock picking—plays a crucial role. 

 

In Brief

  • Research published in 1986 resulted in the “90% Rule,” the notion that more than 90% of a portfolio’s long-run return comes from its asset allocation. This spurred a shift toward passive vehicles such as index funds and exchange-traded funds.

  • Recently, the 90% rule was debunked by Roger Ibbotson and others in an analysis that demonstrates that asset allocation and active management account for nearly equal portions of portfolio returns.

  • Not all styles of active management, though, are equally consistent in achieving outperformance.

  • Actively managed funds that do “diversified stock picking” have beaten their benchmarks more consistently than other forms of management, according to Active Share research.

  • The key takeaway: Owing to the influence of the Ibbotson study and of Active Share research, it is now clear that active management, especially stock picking, has been a critical source of outperformance.

 

Almost 30 years ago, a study was published that today shapes the way many advisors and institutions approach investing. Purported to demonstrate that more than 90% of a portfolio’s long-run return comes from its asset allocation, the study eventually paved the way for a broad move away from traditional practice. Instead of opting for actively managed strategies, advisors and institutions began to focus on assembling portfolios from passive vehicles such as index funds and exchange-traded funds (ETF).

Over the years, many have expressed concerns about the study, which was written by Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower. But the question of the precise role of asset allocation has remained unanswered. In 2010, however, portfolio management expert Roger Ibbotson and his colleagues brought new clarity to the debate. If correct, their findings hold enormous implications for those who forgo actively managed strategies. Walter Prahl, Lord Abbett Partner & Director of Quantitative Research, weighs in on the controversy.

The 90% Solution?
The “Determinants of Portfolio Performance” (1986) was intended to help pension plans choose between active and passive managers. The Brinson, Hood, and Beebower study (or BHB, as it came to be known) examined the quarterly returns of 91 pension plans over the 10-year period from 1974 to 1983. 

The authors found that a pension plan’s long-term asset allocation accounted for 93.6% of the volatility of returns from quarter to quarter. That is, quarterly variations resulted largely from how the plan allotted its assets among stocks, bonds, cash, and other alternatives. (A 1991 update reduced the 93.6% figure to 91.5%. On the basis of the two studies, the authors concluded that “more than 90%” of return variability comes from asset allocation.)

But instead of interpreting it in relation to quarterly volatility, many investors applied it to long-run outcomes. As a result, the “90% rule” became conventional wisdom, and index funds and ETFs proliferated as asset allocation became the preferred strategy for achieving long-term returns.

Some researchers, however, had qualms with the study right from the start, noting, for example, the confusion about return variation versus return outcomes.1 But once the 90% rule became broadly accepted, the implication became clear: If performance comes largely from the asset allocation, then why bother with actively managed funds. Why not focus instead on assembling portfolios with risk-appropriate asset mixes? If performance is driven by the selection of asset classes and not from the selection of securities or from other forms of active management, then why not opt for low-cost ETFs?

Asset Allocation: Strategic or Tactical?
Some confusion about the BHB study’s findings was perhaps inevitable. The original study, in particular, could have better distinguished volatility from performance. And, as we’ll see, the BHB study credited asset allocation with the large amount of variation that is attributable to the market itself. But marketers also added to the confusion by capitalizing on some misunderstanding about two types of asset allocation.

The BHB study’s findings addressed strategic allocation, also referred to as policy, or static, allocation. A plan’s strategic allocation is set by an investor policy committee after considering the desired return and risk tolerance. When the share of one or more asset classes drifts too far, the investor may “rebalance” periodically, but the goal is to return the asset classes to their original apportionment, not to capitalize on current market conditions.

Tactical allocation, on the other hand, involves shifting assets frequently, based on current conditions. The BHB study’s 90% figure did not apply to these short-term moves. In fact, the study classified this as a form of active management, along with security selection, and found that it contributed little to quarterly performance.

 

Table 1. Tactical Asset Allocation Is a Form of Active Management


Source:  Lord Abbett.
See definition of “factor betting” in the “Active Management: Top-Down or Bottom-Up?” section of the article.

 

Some blurring of the lines continues today. One marketing flier, for example, offers strategic model portfolios based on seven- to 10-year investment outlooks while touting that an investment committee meets regularly to “identify investment opportunities.” Allocations come from the committee’s “analysis of various economic, political, regulatory, and global issues.”

But this is tactical asset allocation, and “that is not what Brinson was talking about at all,” said Prahl. “[Brinson] was clearly talking about strategic policy targets toward which a portfolio is periodically rebalanced. The claim of the Brinson study is that strategic, not tactical, allocation accounts for over 90% of the variation in returns. Tactical allocation is explicitly part of the remainder that [Brinson et al.] say explains very little of the variation in portfolio returns.”

Where the 90% Really Comes From
To isolate the effects of a strategic asset allocation, a proper basis of comparison is needed.2 One option is to compare the portfolio to major market benchmarks, which reflect no allocation decision.

Using major benchmarks to represent the capital markets as whole, portfolio management expert Ibbotson and colleague Paul Kaplan, director of the Morningstar Center for Quantitative Research, tested this idea in 2000.3 They found that, indeed, the quarterly variation of the S&P 500® Indexexplained 75% of funds’ monthly movements, leaving only 25% for asset allocation and active management.

This is where the BHB study failed. It neglected to control for, or factor out, the effect of the market as a whole. And because of this failure, it inadvertently attributed the market effect to the portfolio’s strategic allocation.

The result was that the effect of the strategic allocation was overstated. To understand this, it is helpful to think of the BHB study as analogous a study that tests the effectiveness of two drugs, said Prahl. Suppose that the disease in question is one like pneumonia, from which most patients, say 85%, would eventually recover, whether treated or not. The researchers administer Drug A to one group of patients and then administer both Drug A and Drug B to a second group of patients.

In the first group, 90% recover, or 5% more than would have without treatment. In the second group, 95% recover, or 5% more than would have recovered if treated only with Drug A. Both drugs result in an additional 5% recovering, but the researchers mistakenly compare the 95% recovery rate of the first group to the incremental 5% recovery rate of the second group. As a result, they conclude that Drug A is more effective. Clearly this is wrong.  

In the drug study, there were three factors behind the 95% recovery rate: 1) untreated recovery, 2) recovery resulting from Drug A, and 3) recovery resulting from Drug B.

Similarly, in portfolio performance, there are three components: 1) market movement, 2) strategic allocation, and 3) active management. What the BHB study did was to combine the first two in order to compare them to the third.

“The BHB study essentially credits strategic allocation with almost the entire return, including the market return,” said Prahl, “and then credits active management with only an incremental return.” 

Strategic Allocation and Active Management: Equally Important
It was this methodological confusion that had long left the performance attribution question unanswered: Which is more important to portfolio returns: strategic allocation or active management? This question was finally answered in 2010.5

Sampling three peer groups—U.S. equity funds, balanced funds,6 and international equity funds—over a 10-year period (1999–2009), Ibbotson and his colleagues at Ibbotson Associates found that once market effects are factored in correctly, strategic allocation and active management are roughly equal in their contribution to performance.7 In a presentation at the CFA Institute, Ibbotson estimated that market effects account for about 70% of performance (roughly matching his 2000 finding with Kaplan), strategic allocation accounts for 16%, and active management accounts for 14%.8

 

Chart 1. Asset Allocation and Active Management Contribute Similarly to Returns
Contributions to portfolio returns for a statistical sample of U.S. equity funds, balanced funds, and international equity funds, 1999–2009

Data source: Roger G. Ibbotson.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.

 

“Nobody is saying that strategic allocation is unimportant,” said Prahl. “The claim of Ibbotson is very simple, that the contributions of strategic allocation and active management are of approximately equal magnitude.”

With these findings, the confusion has been cleared away. Ibbotson and his colleagues have shown that the debate pitting strategic allocation against active management is now moot. It is not a matter of either/or but both/and.

Active Management: Top-Down or Bottom-Up?
What is the implication for investors? For those who choose to rely on passive vehicles, the answer is clear: they are missing out on a significant source of outperformance, or alpha.9 The choice to rely strictly on passive vehicles is, therefore, more consequential than they have been led to believe.

Active management comes in a variety of styles, however. So, an obvious question is: which one is most likely to outperform?

Broadly speaking, there are two types: top-down and bottom-up. The first approach entails something called factor betting or factor timing. This involves weighting different factors believed likely to generate returns at particular times. Factors can include industry sectors, capitalization sizes, or others. Tactical asset allocation is a form of factor timing applied to a portfolio’s asset mix.

The second type of active management is security selection, in which the primary focus is on valuation and company fundamentals.

So, how does the performance of these two approaches compare? Although both can add value, research on a concept called Active Share has demonstrated that the second approach, bottom-up security selection, outperforms, on average. (See sidebar, “What Is Active Share?”) Portfolio managers who are highly active stock pickers have been better able, on average, to beat their benchmarks.10

This does not mean top-down approaches can’t also outperform. But the Active Share research shows that highly active stock picking has performed better, on average. (The research has focused on equity fund management and has not addressed fixed-income management.)

More specifically, funds that the Active Share researchers call “Diversified Stock Pickers” are more likely than others to outperform. Diversified Stock Pickers score high on Active Share but refrain from top-down considerations—weighting sectors, capitalization, and other factors. These funds have performed better than the other types, beating their benchmarks by an annual average of 1.39% during the period from 1990 to 2009. (See Chart 2.)

All other forms of active management lagged their benchmarks, on average, during this period. “Concentrated Stock Pickers,” for example, score high on Active Share, but also incorporate top-down considerations, over- and underweighting sectors, capitalization, and other factors. These funds failed to add alpha during the period from 1990 to 2009. 

“Moderately Active” funds, which score high on neither the top-down dimension nor the bottom-up dimension, lagged their benchmarks by an average of 2.19% over this period. Similarly, “Factor Bettors,” who score low on Active Share and but moderate to high on the top-down dimension, lagged all but the “Closet Indexers.” Closet Indexers score low on both dimensions, and fell short of their benchmarks by an average of 4.46%. (See Chart 2.)

 

Chart 2. On Average, Historically Only Diversified Stock Pickers Have Beaten Their Benchmarks
Average annual alpha, net of fees, 1990–2009

Source: Antti Petajisto, “Active Share and Mutual Fund Performance,” January 15, 2013.
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.

 

For those invested in model portfolios, these findings are critical. “What the Active Share research has revealed,” said Prahl, “is that managers relying on market timing are less likely, on average, to add value than managers who engage in stock picking.” For those opting for passive portfolios, “stock picking is a lot to give up,” he added. “That’s what the Active Share literature shows.”

Ibbotson’s critique of the 90% rule—combined with Active Share research showing that diversified, highly active stock pickers have consistently added alpha—means that investors should no longer rely strictly on index funds and ETFs for their long-run returns.

After nearly 30 years of misunderstanding, the need to correct the record is long overdue. As Ibbotson has written: “The time has come for folklore to be replaced with reality. [Strategic] asset allocation is very important, but nowhere near 90% of the variation in returns is caused by the specific asset allocation mix. Instead, most…variation comes from general market movement, and…active management has about the same impact on performance as a fund’s specific asset-allocation policy.”11

Reported by Ron Vlieger

What Is Active Share?

Active Share1 is a simple concept—developed by professors K.J. Martijn Cremers of the University of Notre Dame and Antti Petajisto, formerly of New York University—that entails comparing the holdings and weightings of a portfolio with those of its benchmark in order to provide a numerical measure of the degree to which the two diverge. The score can range from zero for a portfolio that matches its benchmark perfectly to 100 for one with no overlap whatsoever. Active Share can, therefore, be interpreted as the portion of a portfolio that differs from the benchmark.

Cremers and Petajisto contrast Active Share with “tracking error,”2 which is another more conventional measure of active management, and argue that the two measures are complementary. While Active Share measures how active a fund is in stock picking, tracking error (or, technically, the volatility of tracking error) measures how active a fund is in more top-down, macro-oriented approaches. Macro-oriented approaches may include, for example, weighting particular sectors, capitalization sizes, and other factors.

Using these two dimensions, Cremers and Petajisto classify actively managed portfolios into five groups. (See Chart 1.) “Diversified Stock Pickers” rely strictly on stock selection and don’t attempt to generate returns by weighting macro factors such as industry sectors. They are diversified in the sense that they don’t overweight or make concentrated bets on sectors or any other such factors. “Concentrated Stock Pickers” combine the two dimensions (stock selection and factor weighting), scoring high on both Active Share and tracking error. They are concentrated in the sense that in addition to picking stocks, they also make large bets on sectors or other factors.

“Factor Betting” portfolios, on the other hand, rely little on stock picking. They focus on weighting sectors and other factors, and therefore score high on tracking error. The fourth group, “Moderately Active,” doesn’t score high on either dimension, falling into the middle quintiles on both Active Share and tracking error. Finally, “Closet Indexers” score low on both dimensions, doing little of either stock picking or factor weighting.

Chart 1. Mutual Funds Can Be Classified by Type and Degree of Active Management
Source: Antti Petajisto, "How Active Is Your Fund Manager? Active Share and Mutual Fund Performance," Morningstar Webinar, November 11, 2010.
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.

 

1 Active share = 1/2 Ν,Σ,i=1 absolute value (weight of stock i in portfolio — weight of stock i in index).
Tracking error (or more formally, tracking error volatility) is commonly defined as the time-series standard deviation of the divergence between a fund return and its benchmark index return. A typical active manager aims for an expected return higher than the benchmark index, but at the same time he wants to have low tracking error (volatility) to minimize the risk of significantly underperforming the index.

1 Unpublished study by Jennifer and John Nuttall, cited by Roger Ibbotson in “The Importance of Asset Allocation,” Financial Analysts Journal (March/April 2010).
2 Chris R. Hensel, D. Don Ezra, and John H. Ilkiw, “The Importance of Asset Allocation,” Financial Analysts Journal (July/August 1991).
3 Roger G. Ibbotson and Paul D. Kaplan, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal (January/February 2000).
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. The index is unmanaged, does not reflect the deduction of fees or expenses and is not available for direct investment.
5 James X. Xiong, Roger G. Ibbotson, Thomas M. Idzorek, and Peng Chen (Ibbotson Associates), “The Equal Importance of Asset Allocation and Active Management,” Financial Analysts Journal (March-April 2010).
6 A balanced fund is a mutual fund that invests in both stocks and bonds. Balanced funds often attempt to provide income and capture price appreciation while maintaining a relatively conservative orientation.
7 Xiong et al., op. cit.
Roger G. Ibbotson, “The Importance of Asset Allocation,” presentation at CFA Institute, May 27, 2010.
9 Alpha refers to the return of a portfolio that is attributable to the efforts of an active manager. In many cases, alpha may be negative. 
10 Antti Petajisto, “Active Share and Mutual Fund Performance,” Social Science Research Network, January 15, 2013.
11 Ibbotson, op. cit.

 

Important Information
Asset allocation does not guarantee a profit or protect against loss in declining markets. The process of rebalancing may carry tax consequences.

Some Risks to Consider:
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.  No investing strategy can overcome all market volatility or guarantee future results.

Lord Abbett does not offer index funds or exchange traded funds (ETFs). An ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.  ETF products, like all investments, are subject to market risk, which may result in loss of principal.  Bond ETF products are subject to interest rate, credit, and inflation risk.  Index funds are constructed to match, or track, the components of specific market indexes, which can be volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. 

Active share is a methodology used to evaluate a fund’s actual performance and volatility against a benchmark. The methodology is not an indicator of how a specific investor’s investment will perform.

This should not be used as a tool or evaluation in making any investment decision. We strongly recommend that you consult with your financial advisor before making an investment decision.

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