The Importance of Asset Allocation

Abstract

This article discusses the impact on performance of the long-term asset allocation policy relative to the impact of active management. Most of the variation in time-series returns for a typical fund comes from general market movement. The remaining variation comes about equally from asset allocation policy and active management.

How important is asset allocation policy in determining performance? In particular, what is the impact of the long-term asset allocation policy mix relative to the impact of the active performance from timing, security selection, and fees?

Most of the variation in a typical fund’s return comes from market movement. Funds differ by asset allocation, but almost all of them participate in the general market instead of just holding cash. The total return of a fund can be split into three parts: (1) the return from the overall market movement, (2) the incremental return from the asset allocation policy of the specific fund, and (3) the active return (the alpha) from timing, selection, and fees.

In general (after controlling for interaction effects), about three-quarters of a typical fund’s variation in time-series returns comes from general market movement, with the remaining portion split roughly evenly between specific asset allocation and the active management. In a year like 2008, almost all funds are down, whereas in a year like 2009, almost all funds are up, despite their specific asset allocation or active management activities.

The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix. Instead, most time-series variation comes from general market movement, and active management has about the same impact on performance as a fund’s specific asset allocation policy.

I gratefully acknowledge the help of James Xiong, Tom Idzorek, and Peng Chen in writing this article.

Notes

¹ Nuttall and Nuttall (1998) surveyed BHB citations in the literature and found that most authors incorrectly thought that the result referred to the return level, not the variation in returns.