A common debate in the investment management field regards asset allocation and security selection. Which is more important? Which causes the greatest dispersion in wealth? The overwhelming consensus within the industry is that asset allocation is more important when assembling your portfolio. When taking a closer look, however, it becomes clear that those who subscribe to that belief fail to distinguish between the consequences of investor behavior, and the opportunity set offered by the capital markets.
Before we get into the methodology that brought us to a result which defies popular opinion, let’s take a look at how that popular opinion was formed, as well as a few people who have gone against it.
1986 – Gary Brinson and his colleagues release a study titled “Determinants of Portfolio Performance,” which attributes the performance of 91 large corporate pension plans to three investment activities: policy, timing, and security selection. They performed regression analyses which revealed that asset allocation policy, on average, accounted for over 93.6% of total return variation through time, and in no case less than 75.5%.
1991 – Brinson et al. updates the study and found that asset allocation policy still accounted for more than 90% of return variation.
2000 – Ibbotson and Kaplan publish an article that supported the Brinson et al. result, but demonstrates that only 40% of return differences across funds is attributable to asset mix policy.
2000 – Ankrim and Hensel object to the Brinson et al. methodology, because it attributes the returns from 0% up to the policy portfolio return to asset allocation. This attribution assumes implicitly that the default exposure is 100% cash.
2000– Jahnke argues that it is difficult to measure the importance of asset allocation because the answer depends on many factors, such as the extent to which investors engage in active asset allocation and security selection, investment expenses and skill.
In order to assess the relative importance of asset allocation and security selection, it is necessary to move beyond historical performance, because these results depend on two separate influences: the investment opportunities available from variation in asset class and security returns, and the extent to which investors chose to exercise discretion in exploiting these opportunities.
Which brings us to question number two.
For the purpose of this investigation, importance is defined as the extent to which a particular investment activity causes dispersion in wealth
In order to solve for this question, we present a simple mathematical model in which the potential for dispersion is measured as the tracking error between two investments (investments that differ by security composition, or investments that differ by asset class composition). Since individual securities are more volatile than asset classes, one may assume that security selection creates more dispersion unless the securities are perfectly correlated. On the contrary, those who subscribe to the belief that asset allocation creates more dispersion, must also believe that high correlations between securities outweigh their high individual volatilities.
In order to put these theories to the test, we start with two asset classes each made up of two separate securities. If we first assume the four securities are uncorrelated with each other, then security selection would be more important than asset allocation because the securities would be riskier than the asset classes containing them resulting in less dispersion among the asset classes. What we are able to deduce from this exercise is that it’s only when the correlation between the asset classes is substantially less than the correlation between the individual securities within the asset classes that dispersion among the asset classes is greater than that among the securities.
When only a few asset classes are considered, the associations between standard deviation, correlation, and tracking error seem clear. However when considering numerous asset classes and weighing them among hundreds of securities with a wide range of volatilities and correlations, the associations become less obvious. When you contemplate the real-world conditions, it is necessary to resolve the question of importance with a simulation procedure called bootstrapping.
Bootstrapping is a procedure by which new samples are generated from an original dataset by randomly selecting observations from the original data set. It differs from Monte Carlo simulation in that it draws randomly from an empirical sample, whereas Monte Carlo simulation draws randomly from a theoretical distribution.
The importance of security selection is measured by holding a constant asset mix at a 60/30/10 allocation among stocks, bonds and cash, and calculating variation in return due purely to variation among randomly diversified stock portfolios. The importance of asset allocation is measured by holding constant security weights and calculating variation in return owing purely to expected allocation of 60/30/10 to stocks, bonds, and cash respectively.
The following table demonstrates the extent to which a talented investor (top 25th or 5th percentile) would improve upon average performance by engaging in asset allocation and security selection. It also shows the extent to which an unskilled investor (bottom 75th or 95th percentile) would perform, depending on the choice of investment discretion.
Percentile Performance Annualized Difference From Average (1988 - 2001), U.S. Investor
So, when questioning the relative importance of asset allocation versus security selection, the answer is clear: