Sector, Style, Region: Explaining Stock Allocation Performance

The importance of asset allocation policy in stock/bond portfolios is widely recognized. Drawing a parallel for equity-only portfolios, this study analyzed the importance of allocation by economic sector and by size and style in purely U.S. stock portfolios and the importance of regional allocation policy in international stock portfolios. The study found that allocation policy explains one-third to nearly three-quarters of among-fund variation in returns, nearly 90 percent of across-time variation, and more than 100 percent of the level of stock portfolio returns. The importance of asset allocation policy in balanced stock and bond portfolios has been the subject of several studies. The first two studies, published in theFinancial Analysts Journal in 1986 and 1991, reported that asset allocation explains more than 90 percent of the variation in a typical portfolio’s performance. Subsequently, researchers have shown that, although more than 90 percent of managed portfolio return variability over time is indeed explained by policy benchmarks, only about 40 percent of the variability among managed portfolios is explained by policy differences. Prior studies analyzed the importance of allocation among broad asset classes, but we focused on equity allocations. We examined what part of a U.S. large-capitalization or small-cap equity fund’s performance is explained by its allocation policy for economic sectors (we used the Global Industry Classification Standard sectors—consumer discretionary, health care, industrials, and so on) or market segments as characterized by size and style as to a value orientation versus a growth orientation. We also examined what part of an international equity fund’s performance is explained by its allocation policy toward world regions. After determining fund policy allocations through style analysis, we regressed total returns on policy returns both in a time-series sense and cross-sectional sense. The R2s of these regressions were used to infer the importance of policy allocations. We also calculated the difference between the gross policy return and total return (both annualized for either a 10-year period of 1995–2004 or a 5-year period of 2000–2004) and compared that difference with reasonable estimates of replication costs. We found that the answer to what role allocation policy plays in returns has three parts. First, allocation policy explains nearly 90 percent of the monthly or quarterly return variability over time. Second, for large-cap and small-cap U.S. funds, allocation policy explains about one-third of monthly or quarterly return variation among funds. For these funds over a recent 5-year period, allocation policy explained close to three-quarters of the return variation in compound annual returns. And for international funds, allocation among regions explains about one-fourth of monthly or quarterly return variation among funds. Finally, policy returns generally exceeded total returns even after accounting for reasonable estimates of the cost for passive replication of the policy mix. Thus, generally more than 100 percent of fund return level is explained by the policy allocation.