Importance of asset allocation strategy
in determining performance
The research paper by Roger G Ibbotson tries to determine (in mathematical terms) how important asset allocation strategy is to overall returns generating capacity of a portfolio.
The total return of a fund comes from different factors. The study determines how much percentage, each of these factor contributes to the total return.
(1) the return generated from movements in the market,
(2) the incremental return generated specifically from the asset allocation policy related to a specific fund, and
(3) the return generated from active portfolio management strategy such as selection of securities, timing of trade and fees (also called the alpha return) (Ibbotson, 2010, p.19)
Time series total return variation data for funds has been used. To compare the components in this data and avoid the flaw in the BHB analysis, this data has been compared to a suitable benchmark. This benchmark was a broad based equity index, as most of the variation can be attributed to equity and other asset classes are relatively stable.
A previously proven hypotheses by Brinson, Hood, and Beebower (BHB 1986); was taken into consideration, and an alternate hypotheses was formed, to prove the former wrong. Then the data (R2) that was used in BHB and compared with cash as a benchmark was changed. The new benchmark was a broad based equity index. Thus the results proved the new hypotheses. Asset allocation strategy is important, but does not attribute 90%+ to the performance of the fund.
The findings of the study conducted, mathematically proved that about three-quarters of a funds variation in returns over time come from general movements in the market, with the remainder roughly divided between specific asset allocation and active management. For example, in a typical good year, all funds will be up, despite choosing different funds, and in a bad year like 2008, where stock market crashes, or the economy is in a bad shape, all the funds generally will be down (and specific fund allocation can only do so much to abate it). Thus asset allocation strategy is responsible for any alpha returns that are earned, but most of the performance still comes from movements in the market.
There was some vocabulary that was new. My learning of the definitions is given below:
R squared: The R squared is a statistical measure that signifies the percentage of return in a fund that can be attributed to movements in a benchmark index (or the market in general). The return of a bond based fund is usually compared to a risk free government security and return of an equity fund is compared to a broad based market index.
Beta : The systematic risk of an investment or a portfolio in comparison to the market as a whole is called Beta. Beta is used in the Capital asset pricing model (CAPM) to calculate expected return based on its risk.
Alpha return: The excess return earned on an investment as compared to it calculated risk is the alpha return of a security. This return is usually attributed to active management of a portfolio (as opposed to passive portfolio strategy).
Asset allocation policy: Asset allocation is an financial asset management strategy that aims at balancing risk of the portfolio to its expected return. This is done in accordance with an individual's risk appetite, goals and investment horizon. (Investopedia 2003)
References
Ibbotson R. G. (2010). The importance of asset allocation. Financial Analysts Journal, Volume 66 , Number 2, 18-20
Asset Allocation Definition | Investopedia. (2003). Retrieved March 13, 2016, from http://www.investopedia.com/terms/a/assetallocation.asp?layout=orig
