The Equal Importance of Asset Allocation and Active Management

Abstract

What is the relative importance of asset allocation policy versus active portfolio management in explaining variability in performance? Considerable confusion surrounds both time-series and cross-sectional regressions and the importance of asset allocation. Cross-sectional regressions naturally remove market movements; therefore, the cross-sectional results in the literature are equivalent to analyses of excess market returns even though the regressions were performed on total returns. In contrast, time-series analyses of total returns do not naturally remove market movements. Time-series analyses of excess market returns and cross-sectional analyses of either total or excess market returns, however, are consistent with each other. With market movements removed, asset allocation and active management are equally important in determining portfolio return differences within a peer group. Finally, an examination of period-by-period cross-sectional results reveals why researchers using the same regression technique can get widely different results.

Our study helped identify and alleviate a significant amount of the long-running confusion surrounding the importance of asset allocation. First, by decomposing a portfolio’s total return into its three components—(1) the market return, (2) the asset allocation policy return in excess of the market return, and (3) the return from active portfolio management—we found that market return dominates the other two return components. Taken together, market return and asset allocation policy return in excess of market return dominate active portfolio management. This finding confirms the widely held belief that market return and asset allocation policy return in excess of market return are collectively the dominant determinant of total return variations, but it clarifies the contribution of each.

More importantly, after removing the dominant market return component of total return, we answered the question, Why do portfolio returns differ from one another within a peer group? Our results show that within a peer group, asset allocation policy return in excess of market return and active portfolio management are equally important. Critically, this finding is not the result of a mathematical truth. In contrast to the mathematical identity that in aggregate, active management is a zero-sum game (and thus, asset allocation policy explains 100 percent of aggregate pre-fee returns), the relative importance of both asset allocation policy return in excess of market return and active portfolio management is an empirical result that is highly dependent on the fund, the peer group, and the period being analyzed.

The key insight that ultimately enabled us to conclude that asset allocation policy return in excess of market return and active portfolio management are equally important is the realization that cross-sectional regression on total returns is equivalent to cross-sectional regression on excess market returns because cross-sectional regression naturally removes market movement from each portfolio. We believe that this critical and subtle fact has not been clearly articulated in the past and has been overlooked by many researchers, especially when interpreting cross-sectional results vis-à-vis the overall importance of asset allocation.

The insight that cross-sectional regression naturally removes market movement leads to the notion that removing market movement from traditional total return time-series regression is necessary should one want to put the time-series and cross-sectional approaches on an equal footing. After putting the two approaches on an equal footing, we found that the values of R² for the excess market time-series regressions and the cross-sectional regressions (on either type of return) are consistent.

Finally, by examining period-by-period cross-sectional results and highlighting the sample period sensitivity of cross-sectional results, we explained why different researchers using the same regression technique can get widely different results. More specifically, cross-sectional fund dispersion variability is the primary cause of the period-by-period cross-sectional R² variability.