If you've been overdosed on caffeine by investment counselors, you've probably suffered some lectures on asset allocation. This is a somewhat stilted concept describing how your capital is being spread across different asset classes, like stocks and bonds.
An established truth?
Moreover, I suspect you may have been told that 90 per cent of the portfolio return is down to asset allocation, while the actual management of your funds explains the rest. I've heard this spiel several times, I've seen it in print, and I know the likely origin. Some 32 years ago, the Financial Analysts Journal published an article titled «Determinants of Portfolio Performance». It does look a bit like a definitive clarification, doesn't it?
The authors set out to examine the importance of investment policy, market timing and security selection, respectively. The following quote points to a clear conclusion: «On average, policy returns accounted for 91.5 per cent of the variance of actual returns». Several researches (and practitioners) have later cited and elaborated on their article.
Hence the established truth that asset allocation (investment policy) accounts for 90 per cent of the return. But wait – did you read it sufficiently carefully to spot the real message?
They concluded that investment policy accounted for 91.5 per cent of the variance of returns. Now that's something completely different. Surely of interest to academic researchers, less so for practitioners. The question does offer some cool food for thought, however, and I believe a carefully chosen example from our own ranks offers an insightful illustration.
In our product range we have but one plain hybrid fund. Its allocation to equities has varied considerably over time – between 46 and 95 per cent since the present senior manager took charge almost 12 years ago. This permits an interesting calculation.
Here, you see, there is a clear and nifty conclusion: During this period the tactical allocation in the fund (continuous changes in allocation to equities) has delivered an annual contribution to the compound return of a full 2.25 percentage points. Given the average annual total return of just over nine per cent, it is evident that the continuous allocation changes have been profitable.
The reason is plain to see: The fund reduced its equity share in the runup to the great financial crisis, and then raised it again in the midst of the crisis. In the following years, the fund has held a consistently higher allocation to equities.
Halfway through 2013 the fund changed its investment universe from Norway to the Nordics, due to a fund merger. Since then, it appears, we find absolutely no effect, either way, of the changes in equity allocation – if anything it actually reduced returns. Annual compound return amounted to 14 per cent, but that is mostly due to successful stock selection. As for allocation, the fund might as well have had a fixed equity share throughout this entire period.
Asset allocation, then, has made absolutely no difference since June 2013.
Ahem ... if, as I suspect, that is how you read it, you are truly mistaken. Committing an illuminating mistake, I might add.
Even if we subtracted the excess return arising from the successful stock selection, the fund would have had a compound return of close to ten per cent since the summer of 2013. This is generally due to the continuing bull market – and to the fund having a consistently high allocation to equities.
After all, then, allocation really is the dominant cause of returns. The single most important decision has been maintaining a high allocation to equities for several years in a row. You might say that this is a tactical consideration, reflecting consecutive market outlooks during this period, but to some extent, it represents a strategic decision to keep a fair share and then some in stocks, in order to reap sufficient long-term returns. If you want to separate strategic from tactical allocation, you would have to draw a line that simply isn't there – at least not in the case of our hybrid fund.
It's all about semantics
Furthermore, splitting percentages is a decidedly woolly operation. If you were to achieve an excess return of 4.4 percentage points in an otherwise flat market, would you claim that stock selection accounts for 100 per cent of the total return? Alternatively, if you deliver a negative excess return of similar magnitude in the same flat market, would you be able to say that allocation represents way above 100 per cent?
In conclusion, this is really a question of semantics. With the different asset classes expected to deliver such wildly different returns, accentuating the importance of asset allocation borders on the banal. Just don't pretend that financial research has arrived at a fixed percentage rule that holds across time, markets and financial instruments.
“Eighty percent of success is showing up.”