Asset Allocation - Academic Studies

Academic Studies

In 1986, Gary P. Brinson, L. Randolph Hood, and SEI's Gilbert L. Beebower (BHB) published a study about asset allocation of 91 large pension funds measured from 1974 to 1983. They replaced the pension funds' stock, bond, and cash selections with corresponding market indexes. The indexed quarterly return were found to be higher than pension plan's actual quarterly return. The two quarterly return series' linear correlation was measured at 96.7%, with shared variance of 93.6%. A 1991 follow-up study by Brinson, Singer, and Beebower measured a variance of 91.5%. The conclusion of the study was that replacing active choices with simple asset classes worked just as well as, if not even better than, professional pension managers. Also, a small number of asset classes was sufficient for financial planning. Financial advisors often pointed to this study to support the idea that asset allocation is more important than all other concerns, which the BHB study lumped together as "market timing". One problem with the Brinson study was that the cost factor in the two return series was not clearly discussed. However, in response to a letter to the editor, Hood noted that the returns series were gross of management fees.

In 1997, William Jahnke initiated debate on this topic, attacking the BHB study in a paper titled The Asset Allocation Hoax. The Jahnke discussion appeared in the Journal of Financial Planning as an opinion piece, not a peer reviewed article. Jahnke's main criticism, still undisputed, was that BHB's use of quarterly data dampens the impact of compounding slight portfolio disparities over time, relative to the benchmark. One could compound 2% and 2.15% quarterly over 20 years and see the sizable difference in cumulative return. However, the difference is still 15 basis points (hundredths of a percent) per quarter; the difference is one of perception, not fact.

In 2000, Ibbotson and Kaplan used five asset classes in their study Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? The asset classes included were large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash. Ibbotson and Kaplan examined the 10 year return of 94 US balanced mutual funds versus the corresponding indexed returns. This time, after properly adjusting for the cost of running index funds, the actual returns again failed to beat index returns. The linear correlation between monthly index return series and the actual monthly actual return series was measured at 90.2%, with shared variance of 81.4%. Ibbotson concluded 1) that asset allocation explained 40% of the variation of returns across funds, and 2) that it explained virtually 100% of the level of fund returns. Gary Brinson has expressed his general agreement with the Ibbotson-Kaplan conclusions.

In both studies, it is misleading to make statements such as "asset allocation explains 93.6% of investment return". Even "asset allocation explains 93.6% of quarterly performance variance" leaves much to be desired, because the shared variance could be from pension funds' operating structure. Hood, however, rejects this interpretation on the grounds that pension plans in particular cannot cross-share risks and that they are explicitly singular entities, rendering shared variance irrelevant. The statistics were most helpful when used to demonstrate the similarity of the index return series and the actual return series.

A 2000 paper by Meir Statman found that using the same parameters that explained BHB's 93.6% variance result, a hypothetical financial advisor with perfect foresight in tactical asset allocation performed 8.1% better per year, yet the strategic asset allocation still explained 89.4% of the variance. Thus, explaining variance does not explain performance. Statman says that strategic asset allocation is movement along the efficient frontier, whereas tactical asset allocation involves movement of the efficient frontier. A more common sense explanation of the Brinson, Hood, and Beebower study is that asset allocation explains more than 90% of the volatility of returns of an overall portfolio, but will not explain the ending results of your portfolio over long periods of time. Hood notes in his review of the material over 20 years, however, that explaining performance over time is possible with the BHB approach but was not the focus of the original paper.

Bekkers, Doeswijk and Lam (2009) investigate the diversification benefits for a portfolio by distinguishing ten different investment categories simultaneously in a mean-variance analysis as well as a market portfolio approach. The results suggest that real estate, commodities, and high yield add most value to the traditional asset mix of stocks, bonds, and cash. A study with such a broad coverage of asset classes has not been conducted before, not in the context of determining capital market expectations and performing a mean-variance analysis, neither in assessing the global market portfolio.

Doeswijk, Lam and Swinkels (2012) argue that the portfolio of the average investor contains important information for strategic asset allocation purposes. This portfolio shows the relative value of all assets according to the market crowd, which one could interpret as a benchmark or the optimal portfolio for the average investor. The authors determine the market values of equities, private equity, real estate, high yield bonds, emerging debt, non-government bonds, government bonds, inflation linked bonds, commodities, and hedge funds. For this range of assets, they estimate the invested global market portfolio for the period 1990-2011. For the main asset categories equities, real estate, non-government bonds and government bonds they extend the period to 1959-2011.