Over the long term, savings accounts pay you about 4% interest. The stock market pays about 9.5%. Why is there such a big difference?
The short answer is that when you invest in the stock market, you’re taking a risk that you might not get all of your money back when you cash out. If savers are going to take such a risk, they demand to be compensated for it, and this explains the higher average returns.
Where does this extra return come from? Why does one mutual fund make 12% in a given year, while another fund only makes 8% in the same year? Is it because one portfolio manager is smarter than the other? Or is it just that one of them got lucky while the other did not? For answers to this question, we turn to a study done in 2000 that revealed some interesting and unexpected answers.
Does Asset Allocation Policy Explain 40, 90, 100 Percent of
Performance?
Roger G. Ibbotson, Yale School of Management; Zebra Capital Management, LLC
Paul D. Kaplan, Morningstar, Inc.
Financial Analysts Journal, Jan/Feb 2000, Vol. 56, No. 1
Executive Summary:
Does asset allocation policy explain 40 percent, 90 percent, or 100 percent of performance? According to some well-known studies, more than 90 percent of the variability of a typical plan sponsor’s performance over time is attributable to asset allocation. However, few people want to explain variability over time. Instead, an analyst might want to know how important it is in explaining the differences in return from one fund to another, or what percentage of the level of a typical fund’s return is the result of asset allocation. To address these aspects of the role of asset allocation policy, we investigated these three questions.
1. How much of the variability of returns across time is explained by asset allocation policy?
2. How much of the variation of returns among funds is explained by differences in asset allocation policy?
3. What portion of the return level is explained by returns to asset allocation policy?
We examined 10 years of monthly returns to 94 balanced mutual funds and 5 years of quarterly returns to 58 pension funds. For the mutual funds, we used return-based style analysis for the entire 120-month period to estimate policy weights for each fund. We carried out the same type of analysis on quarterly returns of 58 pension funds for the five-year 1993-97 period. For the pension funds, rather than estimated policy weights, we used the actual policy weights and asset-class benchmarks of the pension funds.
We answered the three questions as follows:
#1: We regressed each fund’s total returns against its policy return and recorded the RSQ value for each fund in the study. We found that, on average, about 90 percent of the variability of returns of a typical fund across time is explained by asset allocation policy. Most of a fund’s ups and downs are explained by the ups and downs of the overall market.
#2: We ran a cross-sectional regression of compound annual fund returns for the entire period on compound annual policy returns. We found that about 40 percent of the variation of returns from one fund to another is explained by policy return differences. For example, among mutual funds, if one fund’s return is 13 percent and another fund’s return is 8 percent, then on average, about 2 percent of the difference is explained by the difference in asset mix policy; the remaining 3 percent difference is explained by other factors, such as timing, security selection, and fee differences between the funds.
#3: For each fund, we divided the compound annual policy return for the entire period by the compound annual fund return. We found that, on average, about 100 percent of the return level is explained by the return to asset allocation policy. Thus, the average fund’s return to asset-mix policy is about the same as the return to the benchmarks for the asset classes.
In summary, our analysis shows that asset allocation explains about 90 percent of the variability of a fund’s returns over time but explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset allocation policy explains slightly more than 100 percent of the levels of returns. Thus, the answer to the question of whether asset allocation policy explains 40 percent, 90 percent, 100 percent of performance, depends on how the question is interpreted.
JEL Classifications: G11
Accepted Paper Series
Asset allocation policy means the way the portfolio is divided among major categories of investment types, such as stocks, bonds, and cash. Timing means the switching between the various asset classes.