A Review of “The Importance of Asset Allocation”
The article talks about the importance of asset allocation policy, and how much of the total return comprises of return due to asset allocation policy.
The article starts off by illustrating the previous studies done by Brinson, Hood, and Beebower (BHB 1986), Hensel, Ezra, and Ilkiw (HEI 1991) and Ibbotson and Kaplan (2000). These studies are considered one of the main milestones in determining the role asset allocation plays in achieving a higher return.
The article points out that although BHB study had pointed out that over 90% of the variation in total return is due to asset allocation, both HEI and Ibbotson and Kaplan had showed that large portion of the return component was general market movement and that asset allocation contributed about thirty to forty percent (Ibbotson, 2010).
The article also explains that the total return of any fund or portfolio comes from three main components, the return from the overall market movement return from asset allocation policy, and active return (alpha) due to timing and selection.
The article states that BHB in their study had taken the first and the second part, i.e. general market movement return and asset allocation policy return together. This resulted in R2 due to this component being ninety percent (Ibbotson, 2010).
However, in HEI and Ibbotson and Kaplan studies, the asset allocation policy return was taken separately, which explained the differences in results. A graph shows the contribution of various components in total return for the four major studies.
The article makes the final comment that although BHB study is used as a cornerstone in assuming that asset allocation plays a huge role in total return, it is the general market movement which explains most of the return for any portfolio or fund and asset allocation plays a lesser important role, which was pointed out using example of fund returns in 2008 and 2009 crisis and brief recovery periods (Ibbotson, 2010).
I disagree with the hypothesis of the paper by Ibbotson that asset allocation is not as important as it is made out to be. Although the empirical study by Ibbotson shows that general market movement is the major reason for variation in total return, over the last few years it has been proven by other studies that asset allocation is at least as important as active return, after general market movement is taken out (Idzorek, 2010).
In times of crisis or slowdown, it has been shown that different asset classes can generate hugely different returns. This shows the importance of asset allocation in generating higher returns (Idzorek, 2010).
The terms used in the article, which were new to me, were alpha, balanced funds, and market-neutral hedge fund. I may have not heard these terms before or don’t know the exact meaning.
According to my understanding, alpha is the excess return for a portfolio or a fund, above its benchmark return. This excess return can be generated through changes in portfolio composition or through better timing of investment.
Balanced funds or hybrid funds are the ones which have both equity and debt securities. The weight age assigned to these two asset classes may vary from one portfolio to another.
Market neutral hedge fund is the one which has zero beta, i.e. it has no systematic risk. This can be achieved through diversification of portfolio. Such a fund will have risk profile of only individual securities.
References
Ibbotson, R. G. (2010). The Importance of Asset Allocation. Journal of Financial Analysts. 66(2), 18-20.
Idzorek, T. M. (2010). Asset Allocation Is King. Morningstar Advisor. Retrieved from https://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/AssetAllocationIsKing.pdf.
