Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?

Disagreement over the importance of asset allocation policy stems from asking different questions. We used balanced mutual fund and pension fund data to answer the three relevant questions. We found that about 90 percent of the variability in returns of a typical fund across time is explained by policy, about 40 percent of the variation of returns among funds is explained by policy, and on average about 100 percent of the return level is explained by the policy return level. Does asset allocation policy explain 40 percent, 90 percent, or 100 percent of performance? The answer depends on what the analyst is trying to explain. According to some well-known studies, more than 90 percent of the variability of a typical plan sponsor's performance over time is attributable to asset allocation. So, if an analyst is trying to explain the variability of returns over time, asset allocation is very important. The results of previous studies are often applied, however, to questions the studies never intended to address. Rather than the importance of asset allocation over time, an analyst might want to know how important it is in explaining the differences in return from one fund to another or what percentage of the level of a typical fund's return is the result of asset allocation. To address these aspects of the role of asset allocation policy, we investigated these three questions: How much of the variability of returns across time is explained by asset allocation policy? How much of the variation of returns among funds is explained by differences in asset allocation policy? What portion of the return level is explained by returns to asset allocation policy? We examined 10 years of monthly returns to 94 balanced mutual funds and 5 years of quarterly returns to 58 pension funds. For the mutual funds, we used return-based style analysis for the entire 120-month period to estimate policy weights for each fund. We carried out the same type of analysis on quarterly returns of 58 pension funds for the five-year 1993–97 period. For the pension funds, rather than estimated policy weights, we used the actual policy weights and asset-class benchmarks of the pension funds. We answered the three questions as follows: Question #1: We regressed each fund's total returns against its policy returns and recorded the R2 value for each fund in the study. We found that, on average, about 90 percent of the variability of returns of a typical fund across time is explained by asset allocation policy. Most of a fund's ups and downs are explained by the ups and downs of the overall market. Question #2: We ran a cross-sectional regression of compound annual fund returns for the entire period on compound annual policy returns for the entire period. The R2 statistics from this regression showed that for the mutual funds, 40 percent of the return difference from one fund to another (and for the pension fund sample, 35 percent) is explained by policy differences. For example, among mutual funds, if one fund's return is 13 percent and another fund's return is 8 percent, then on average, about 2 percent of the difference is explained by the difference in asset mix policy; the remaining 3 percent difference is explained by other factors, such as timing, security selection, and fee differences between the funds. Question #3: For each fund, we divided the compound annual policy return for the entire period by the compound annual fund return. We found that, on average, about 100 percent of the return level is explained by the return to asset allocation policy. Thus, the average fund's return to asset-mix policy is about the same as the return to the benchmarks for the asset classes. In summary, our analysis shows that asset allocation explains about 90 percent of the variability of a fund's returns over time but explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset allocation policy explains slightly more than 100 percent of the level of returns. Thus, the answer to the question of whether asset allocation policy explains 40 percent, 90 percent, or 100 percent of performance depends on how the question is interpreted.