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Policy Myths: Reconnecting Investors with

Useful Insights
June 4, 2015
by David Robertson
of Arete Asset Management
Sometimes things evolve over time in order to better adapt to environmental changes and ...
sometimes they don't. Few would argue, for example, that the QWERTY keyboard is the most
efficient layout for typing messages. In the day of mechanical typewriters, it made great sense - so
as to minimize the chances of keys hitting one another. Today, absent mechanical constraints, the
keyboard layout is not nearly as fit for the purpose of efficient communication.
Similar fates befall theories and models as well and perhaps especially so in the realm of investing.
With thousands upon thousands of service providers in various forms, all competing for the attention
of investors, it's not surprising that some interpretations and applications of theory dont withstand
the test of time well. The role of asset allocation, in particular, falls into this category.
The question of the importance of asset allocation was addressed in an influential paper published
back in 1986 by Brinson Hood and Beebower (BHB) and called "Determinants of Portfolio
Performance" [<span "font-size:13.5pt;font-family:"tahoma","sans-serif";mso-fareast-font-family:=""
"times="" roman""="">here]. In that study the authors regressed time series returns of a number of
funds and concluded that the asset allocation policy mix explained 93.6 percent of the average fund's
return variation over time.
What happened next was interesting and has shaped the investment industry ever since. Supported
by evidence that asset allocation was the pre-eminent investment concern, the landscape of pension
consulting and wealth management firms blossomed and specialized in, you guessed it, asset
allocation policy. Also, not surprisingly, since asset allocation seemed to command such a prominent
role in the investment process, it was relatively easy to charge handsomely for the activity.
The only problem is that much of the rationale that spurred this development was largely misguided.
One problem, as often happens when research goes mainstream, is that it was widely
misinterpreted. As Roger Ibbotson notes [<span "font-size:13.5pt;font-family:"tahoma","sansserif";mso-fareast-font-family:="" "times="" roman""="">here], "many investors mistakenly believed
that the BHB (1986) result (that asset allocation policy explains more than 90 percent of
performance) applies to the return level." It did not. Rather, BHB clearly stated that the 90 percent
applies to return variation.
This may seem like a trivial distinction, but it carries enormous implications for investors. By focusing
on return variation, The BHB results attributed the variation between fully invested portfolios and
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cash to asset allocation. The study didn't really answer the question that is most relevant to
investors: "Why does your return differ from mine?" Ibbotson, along with co-authors Xiong, Idzorek,
and Chen [<span "font-size:13.5pt;font-family:"tahoma","sans-serif";mso-fareast-font-family:=""
"times="" roman""="">here], sought to address this gap by answering a more specific and
meaningful question, "What is the impact of the long-term asset allocation policy mix relative to the
impact of active performance from timing, security selection, and fees?"
They got a very different answer: "In general (after controlling for interaction effects), about threequarters of a typical funds [portfolios] variation in time-series returns comes from general market
movement, with the remaining portion split roughly evenly between the specific asset allocation and
active management." At least part of the reason for the different result was the realization that, "The
BHB methodology incorrectly ascribed all 100 percent of the return variation to asset allocation,
whereas, in fact, all the variation came from stock selection and general market movement."
Ibbotson concludes, "The time has come for folklore to be replaced with reality. Asset allocation is
very important, but nowhere near 90 percent of the variation in returns is caused by the specific
asset allocation mix. Instead, most time-series variation comes from general market movement, and
Xiong, Ibbotson, Idzorek, and Chen (2010) showed that active management has about the same
impact on performance as a funds specific asset allocation policy."
The implications of these findings for investors range broadly. For one, active management, in the
form of security selection and timing of exposures less fees, is far more important than many
investors and service providers believe. Conversely, asset allocation is far less important. This reality
is increasingly being borne out by some of the robo-advisory offerings that offer basic asset
allocation at much lower prices and also by investors who can make allocation decisions on their
own in order to save a lot of money.
Another implication of these findings is that it illuminates yet another reason why there is so little
trust in the financial services industry. As The Financial Times highlights [<span "fontsize:13.5pt;font-family:"tahoma","sans-serif";mso-fareast-font-family:="" "times="" roman""="">here],
The deepening sense of detachment between the rulers and the ruled" as it relates to politics, so too
has there been a detachment between investment service providers and investors. While there are
many sources for this "detachment", the predilection to overcharge and the uncritical application of
theory are important ones. Nobody is perfect, things change, and we learn over time, but investors
expect service providers to at least try.
Yet another possible implication of these findings is that the importance of active management may
be on the rise. Given the extended period of low rates, rising asset prices, and suppressed volatility
since 2009, and since 1982 in a broader sense, it has been a favorable environment for asset
allocation relative to active management. As the tide turns, rates rise, and volatility re-emerges,
security selection and timing may well take on greater importance relative to asset allocation policy.
After 33 years of simply having to "hoist a sail" to capture the tailwinds of rising asset prices, it
doesn't seem unreasonable that investors may need to work harder by rowing through choppy
waters to get ahead in the future.

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Finally, while investors do face plenty of challenges, it would be unfair to say that there aren't a lot of
really useful ideas about investing out there. The problem isn't a lack of good research but rather a
lack of efficient, effective, and unbiased dissemination. With all of the great technology tools
available, this is no longer a logistical problem but rather a business choice. And if the investment
environment gets more challenging, there ought to be plenty of demand for it.
Arete Asset Management

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