How important is asset allocation?

Morningstar's director of research Paul Kaplan debunks some myths about how much of a portfolio’s performance is explained by asset allocation.

Paul Kaplan 16 July, 2012 | 1:00PM Christian Charest
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Christian Charest: It's become generally accepted that the asset allocation decision explains the lion's share of a portfolio's performance. Now whether it explains 40%, 50%, 90% or even a 100%, is still open for debate. What is certain is that there is still a lot of confusion out there about what exactly this percentage means.

With me to talk about this is Morningstar Canada's Director of Research, Dr. Paul Kaplan. Now, Dr. Kaplan is an expert on all things asset allocation and his latest book is entitled, Frontiers of Modern Asset Allocation.

Now Paul, thank you for being here. Before we get into exactly the percentage of what is explained by asset allocation, let's define exactly what we mean by that. What exactly does asset allocation explain?

Paul Kaplan: Well, first we need to understand what exactly is asset allocation? Asset allocation is really an investment discipline. It's an approach to constructing a portfolio, and what it does is it says let's break the portfolio construction process into two parts. In the first part, we will take our portfolio and decide what percentage we're going to put into each of the major asset classes. How much we're going to put into equities? How much we're going to put into fixed income? How much we're going to put into cash? We may consider some other asset classes, real estate, commodities, and so on. And we can dig a little deeper and we could say within equities, how much do we want to put in Canadian equities, U.S. equities, European equities, and so on? Similarly with fixed income, we can decide how much do we want to put in long-term bonds, government bonds, corporate bonds, et cetera?

Once we have done that, we've completed that asset allocation phase. The next thing that we do is we say within each of those asset allocation percentages how do we want to implement that asset allocation? Do I want to use an index fund? Do I want to use active managers, open-end mutual funds, ETF, what exactly do I want to do? That really gets into this whole question of the importance of asset allocation, because there are two phases to it. One is dividing the portfolio up into different parts, and the other is implementing that asset allocation through management decisions.

Charest: Based on your studies, what did you find is the actual proportion of the returns that are explained by asset allocation?

Kaplan: Well, one of the problems with this question and the reason there's so much confusion about it, is that different studies have been used to answer different questions that don't necessarily match. So, for example, the question that most people are asking when they're asking this question, how important is the asset allocation? What they mean is, I have this asset allocation. You have that asset allocation that difference in asset allocation that we've chosen how much at the end of the day is that going to determine our differences in performance versus the differences in the managers that we used to implement our different asset allocations. The 90% number that's thrown around so much actually does not ask that question, it asks a completely different question. What that study asks, it says that if you take one portfolio over time and it has a particular long-term asset allocation and then it implements it differently over time using different managers or different variations, over time how much of the variation in the performance is explained by that asset allocation? And that is where you get the 90% number.

Now, unfortunately that does not answer the question why it – how much does my asset allocation versus your asset allocation explain? It's a completely different question, and that's the source of the confusion. So, to help clarify things, Roger Ibbotson and I back in 2000 published a paper on the importance of asset allocation, where we looked at a few different questions and one of them was the one I first posed, which was, if my asset allocation differs from your asset allocation, how important is that versus the different managers we used? We looked at balanced open end mutual funds, we looked at actual pension funds, and we concluded that explains about 40% of the variation of one fund versus another is due to the asset allocation decision.

More recently Professor Ibbotson has done a study with some of our Morningstar colleagues, namely Tom Idzorek, James Xiong, and Peng Chen, where they used some different methodologies, but they came to basically the same conclusion and they even put the conclusion on the title of the paper, which is called The Equal Importance of Asset Allocation and Manager Selection. So, in other words they are about equally important.

Charest: How can investors use this information?

Kaplan: It's really not particularly useful to investors. It was really more of an academic question because as far as investors are concerned, investors really – I think – need to adapt an asset allocation approach to their investments. They have to sit down preferably with an advisor and figure out, what are my circumstances, what are my needs, what's my risk tolerance? And based on that decide on an asset allocation. Then stick with that asset allocation unless something should change, and then they can also then have a further discussion and decision as to how to implement that asset allocation; the percentage of which is more important is really moot, because you have to do both anyway. So, I don't think investors really need to concern themselves about the exact number about asset allocation versus manager selection, as long as they're doing both they're on the right track.

Christian Charest: Well, thank you very much for clearing all this up, Paul.

Paul Kaplan: Thank you.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.

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