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Is asset allocation a hoax?

In America, and some would say only in America, the Holy Grail of financial planning is being challenged.

Tuesday, February 17th 1998, 12:00AM

by Philip Macalister

In America, and some would say only in America, the Holy Grail of financial planning is being challenged.
A recent study has claimed asset allocation is a hoax. According to the seminal 1986 work by Gary Brinson, Randolph Hood and Gilbert Beebower called "Determinants of Portfolio Performance" asset allocation accounts for 93.6 per cent of a portfolio's return. That report went on to suggest about 2 per cent of returns came from market timing activities and about 4 per cent from security selection.
Not so says Bill Jahnke, the former head of investments for Wells Fargo Bank and one of the earliest proponents of indexing.
His recent study reckons the real impact of asset allocation is closer to the 15 per cent mark.
If so that means the advisers should stop worrying about asset allocation and give portfolio decisions to the best fund managers.

What the Brinson report said
The 1986 report set out to "rank in order of importance the decisions made by investment clients and managers, and then to measure the overall importance of these decisions to actual plan performance."
To do this it used data from 91 large United States pension plans over the period 1974 to 1983.
The report's authors then had to determine each plan's asset allocation mix over the period. Since such precise information was not available in those days the authors "assumed that the 10 year mean average holding of each asset class was sufficient to approximate the normal holding."
Furthermore, assets were lumped into just three categories: shares, bonds and cash.
In determining where the returns came from Brinson et al calculated the mean average annualised return for all the portfolios was 9.01 per cent a year. The study went on to say that the comparable figure from the indexes that represented these three asset classes was 10.11 per cent.
That suggests managers lost 1.1 per cent annually through their investment management process.
The portfolios in the study had broad ranges in their asset allocations, with shares ranging from 32.3 per cent to 86.5 per cent, bonds going from 0-43 per cent and cash from 1.8 per cent to 33.1 per cent.
If managers had indexed their portfolios the returns fell in a tight range of 9.47 per cent to 10.57 per cent, yet the actual range of real returns from the managers was from 5.85 per cent to 13.4 per cent.
Instead of using these numbers the authors compared the actual total return for each quarter against that quarter's calculated investment policy mix using a regression analysis.
That lead to the famous 93.6 per cent figure.

What Jahnke says
The two key factors that skewed the Brinson report are that its key conclusion focuses on quarter-by-quarter variations in returns, not differences in long term returns.
Yet the compounding effect can magnify small performance differences over a long period of time. That is important as investors are more concerned about long term performance than short-term returns.
Secondly, the regression analysis used by Brinson et al looks at each fund's performance relative to itself, not against all the pension plans.
Jahnke says the way to determine how much investment policy or asset allocation really matters is to divide the difference in returns of the hypothetical portfolio (1.1 per cent) by the difference in actual portfolio returns (7.55 per cent).
The answer is a stunning 14.6 per cent.

Adding some weight to the Jahnke camp is US research house Morningstar. Morningstar had a go at re-working the asset allocation numbers with a core group of 63 funds that had a track record of more than 10 years.
It concluded asset allocation does play a part in determining long term returns, however was minor compared to some other factors.
Morningstar says factors controlled by the fund manager, such as a fund's aggressiveness, short-term shifts in style and stock selection appear to make a significant difference in returns.
While admitting this research was not the definitive piece on asset allocation, it said, "it's clear that investors can benefit more from finding funds that consistently add value through security selection, shifts in style and other fundamental factors rather than sweating over the optimal mix of assets and skipping all the other questions."

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