Show me the proof: How important is asset allocation?

26 January 2017 | Peter Westaway


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Key points:

  1. Strategic asset allocation explains 80.5%1 of a diversified portfolio's volatility over time.
  2. It also explains 23.6%1 of a diversified portfolio's terminal value.
  3. Fund and stock selection are important contributing factors to terminal value.
  4. Strategic asset allocation is likely to be the best place to start when building a portfolio to meet your goals.

One of Vanguard's four principles for investing success states that investors give themselves the best chance of success if they develop a suitable asset allocation using broadly diversified funds. This principle is built on the fact that strategic asset allocation is the most important driver of a portfolio's volatility and an important driver of its returns.

So where's the proof?

The idea first gained prominence in 1986 when researchers Gary Brinson, Randolph Hood and Gilbert Beebower (henceforth BHB) published their seminal paper Determinants of Portfolio Performance. Subsequent research by William Jahnke took a different stance, arguing that investors cared more about the terminal value of their investments than they did about variations along the way. Jahnke's 1997 paper, The Asset Allocation Hoax, suggested that BHB's conclusions failed to recognise the impact that fund selection has on terminal values.

Our research suggests that both BHB and Jahnke can be right. It suggests that initial asset allocation is the most important driver of return variations during the holding period, but that fund selection can also significantly affect full-period returns.

Statistics alert!

It's hard to get into this subject without talking statistics, so here goes. We measured the performance of 743 balanced funds – that is, funds investing in a mixture of different asset classes such as equities, bonds and cash – in the United Kingdom over the period from 1990–2015. For each fund, we examined:

  1. The policy return, which we define as the return that the portfolio would have delivered just based on its asset allocation, implemented via index funds; and
  2. The actual return, which is the return investors saw, taking into account the many active decisions taken by most balanced fund managers over time.

We then performed a time-series regression analysis of the funds' actual returns versus their policy returns. The adjusted R-squared derived from this analysis indicates the extent to which asset allocation drives differences during the holding period between the policy returns and actual returns. A high adjusted R-squared would mean that variations in the policy return explained a high percentage of the variation in fund returns.

Our results largely backed up BHB's original conclusion. We found that strategic asset allocation accounted for 80.5% of the variability of returns among the 743 UK balanced funds we examined.2

We then sought to test Jahnke's conclusion by running a cross-sectional analysis to compare actual returns with policy returns. Using this method, the influence of initial allocation on UK balanced funds' terminal values came out lower at 23.6%, suggesting that fund selection was indeed a powerful driver of the actual performance that investors see.

Volatility versus returns

To put our findings another way, asset allocation is the main driver of a portfolio's volatility over time, while both asset allocation and fund selection (as well as other factors including market timing and stock selection) drive terminal values.

For most investors, both the returns over the holding period and the volatility along the way are important considerations – and asset allocation influences both of these factors. So, rather than obsessing about selecting the latest hot funds, we think it's more sensible to start with your asset allocation when you build a portfolio to meet your goals.

1 Source: Vanguard calculations, using data from Morningstar, Inc.

2 We performed similar analysis on the US, Australian, Japanese and Canadian markets and found similar results, ranging from 80.5% (UK) to 91.1% (US).

Important information:

Past performance is not a reliable indicator of future results.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Limited.



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