Tuesday, August 26, 2008

Asset Allocation isn’t Everything

Back in 1986, a study by researchers Brinson, Hood, and Beebower concluded that over 90% of the variance in pension fund returns was determined by their asset allocation decisions rather than the individual equities they chose. Investment advisors like to abuse this statistic for their own gain.

What the researchers did was to replace the pension funds’ individual equities with appropriate indexes and see how much the returns changed. It turned out that they didn’t change much. When a pension fund allocated a fraction of its money to mid-cap stocks, it tended to choose a broad mix of mid-cap stocks that performed very close to the average of all mid-cap stocks. The same thing happened for other asset classes. This isn’t very surprising.

Christopher L. Jones observed in his book, The Intelligent Portfolio, that investment advisors abuse this 90% statistic to steer investors toward investments that are profitable for the advisor. I didn’t recognize it at the time, but I had an investment advisor use this approach on me early in my investing life.

Many investment advisors use a hierarchical approach where they first choose an asset allocation, and then choose individual investments (usually mutual funds) that satisfy the required asset allocation. The implication is that the asset allocation is much more important than the individual investments.

However, choosing a set of mutual funds with high expense ratios is going to hurt the investor’s returns seriously and pay the advisor handsomely no matter what asset allocation is used. Investors need to pay attention to both asset allocation and the expected returns of the individual investment choices.


  1. This sounds a little like my experiment with dollar-cost averaging: naturally the returns will be similar because they are essentially computing the same average two different ways.

  2. Patrick: You're right. If you start with the assumption that pension plans are so large and will be so diversified that they will essentially replicate indexes, then the result is obvious. I guess the study verifies this assumption.

  3. I think you are bang on in that it was abused (and still is) by advisors in that the same advisors who draw upon academic research to promote asset allocation then hide behind wishful thinking when it comes to choosing the investments to achieve the diversification (i.e. a 3% MER on a wrap program versus perhaps a 0.28% MER on a basket of ETFs). The 0.28% translates into 1.28% if you are using an advisor assuming a 1% fee, but for anyone who is following the pf blogosphere, there's no real need to pay this 1% as it is easily done yourself and takes but minutes per year of maintenance.

    A 2.72% advantage per year is gargantuan.

  4. Preet: You anticipated my next post! I'm working on a comparison of the benefits of proper asset allocation versus MERs.

  5. Asset allocation is important.

    But, in my opinion, low fees are even more important when predicting the long-term success of an investment program.

  6. Mark: I agree. Fees can absolutely kill long-term returns.

  7. I am a believer of asset allocation and low fees, but some advisors may be under the impression that the two are mutually exclusive.

    I look forward to your post. The 0.28% fee I mentioned was for a globally diversified portfolio I have used before which I might argue is more diversified than the standard wrap programs. This has some elements of active management in it as it has direct (and overlapping exposure) to infrastructure and agribusinesses and there is a home bias. It also has a play on commodities and international REITS.

    The 0.28% is a weighted average MER based on the following all equity portfolio:

    25.00% S&P/TSX Capped Composite Index
    20.00% Vanguard US Total Stock Market Index
    20.00% MSCI EAFE Index
    10.00% MSCI EM Index
    10.00% S&P Global Infrastructure Index
    5.00% WisdomTree International REIT
    5.00% Deutsche Bank Liquid Commodity Index
    5.00% DAXGLOBAL Agribusiness Index

    5 year returns adjusted for C$ are 16.33%, with standard deviation of 12.81%. These are just my spreadsheet calculations, and not intended as a recommendation - this was just one portfolio that I have used for a particular person based on their tastes and preferences to demonstrate how one can attain asset allocation with low fees.

    Canada's relatively strong performance for the past 5 years hasn't made global asset allocation look too attractive, but 5 years is nothing in the grand scheme of things and Canada could very easily have relative underperformance going forward.

  8. Preet: Thanks for the sample portfolio. An overall MER of only 0.28% is definitely in the right ballpark. That works out to only 6.8% after 25 years. Contrast this with a 3% MER that takes away 53% of your money after 25 years.

  9. It sounds like you are mis-quoting, or mis-paraphrasing the Wikipedia article you linked to. You said:

    "What the researchers did was to replace the pension funds’ individual equities with appropriate indexes and see how much the returns changed. It turned out that they didn’t change much."

    The Wikipedia article said:

    "The indexed quarterly return were found to be higher than pension plan's actual quarterly return. . . The lessons of the study was that replacing active choices with simple asset classes worked just as well as, if not even better than, professional pension managers."

  10. Your post (or at least the subject line) seems to focus on downplaying the importance of asset allocation, whereas really what I think you are trying to say is that cost is very important. NOT that asset allocation is un-important.

    The last sentence, "Investors need to pay attention to both asset allocation and the expected returns of the individual investment choices" may be misleading to some. It seems to me that what you meant was that investors need to pay attention to both asset allocation and cost (which affects expected return). You made this clear in the sentence before, where you said "expense ratios is going to hurt the investor’s returns seriously."

  11. Dave: The results of the study were that replacing individual equities with indexes made little difference. What difference there was favoured the index. So, there is no contradiction. I just chose not to focus on which approach had the small edge.

    I guess it is a matter of taste whether you say "X is important, but Y is more important" or "Y is important, and X is less important." As I will be pointing out in tomorrow's post, you can pay attention to both anyway.

    My intent was that paying attention to "individual investment choices" and paying attention to cost are largely the same thing. Sorry for the confusion.