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of a long-running and controversial debate. The basic question is: Which of these two decisions has a larger impact on a portfolio's performance? As it turns out, the answer to this seemingly simple question is not that simple and, in some sense, it is impossible to provide.

      First, we must specify whether the performance of a diversified or a concentrated portfolio is being measured. Clearly, the performance of a concentrated portfolio that consists of some allocation to cash and the rest to a single stock is mostly determined by the security selection decision. A significant portion of the characteristics of this portfolio's performance through time will depend on the choice of the single stock that constitutes the risky part of the portfolio. The choice of allocating a portion of the portfolio to cash will have some impact on the portfolio's performance, but it will be relatively small. In contrast, security selection is likely to have only a minor impact on the portfolio's performance if its equity portion consists of several thousand stocks that are listed around the world.

      Second, we need to specify what is meant by portfolio performance. Is the impact of asset allocation on expected monthly return the sole criterion for evaluating the importance of asset allocation? How about higher moments of the return distribution or the beta of the portfolio with respect to some benchmark? As will be discussed, what is meant by performance will have an impact on the importance of asset allocation.

      One of the most notable studies on the importance of asset allocation was published in 1986 by Brinson, Hood, and Beebower (BHB). The authors regressed the quarterly rates of return reported by a group of U.S. pension funds against passively managed benchmarks that were created using the weights proposed by the investment policy statements of the pension funds. The goal was to examine the relationship between the actual performance of the funds and the performance that would have been realized had the funds invested their capital in passively managed market indices according to the weights set forth in their investment policy statements. The average r-squared of these regressions exceeded 90 %. Although BHB were clear in presenting their results, the rest of the investment community took the reported r-squared figure and made the blanket statement that more than 90 % of the performance of these pension funds could be explained by the asset allocation decision described in the investment policy and that less than 10 % of the performance could be explained by the active management decisions of the portfolio managers, such as security selection and tactical tilts. This would be the right conclusion if by performance one means the return volatility of the portfolio through time. However, this would be an incorrect conclusion if by performance one means the average return itself through time. In other words, BHB never claimed that 90 % of the average return on diversified portfolios could be explained by the asset allocation decision.

      As discussed in the CAIA Level I book, the r-squared of the regression tells how much of the variation in the dependent variable can be explained by variations in the independent or explanatory variables. In other words, the BHB study only confirmed that more than 90 % of variability in the realized returns of fully diversified portfolios could be explained by the asset allocation decision. More important, it did not say anything about the impact of asset allocation on the average return on those pension funds. The study had a lot to say about the second moment of the funds' return distribution and very little about the first moment of their return distribution. Further, the sample included fully diversified portfolios and therefore could not consider the importance of security selection because the portfolio managers had already decided to fully diversify and not to hold concentrated positions in securities that they considered to be undervalued. In short, the study was not meant to answer some of the most important questions faced by asset allocators, but it did spur a large set of studies that have gradually provided answers to practitioners.

      Three important questions that could be asked and answered regarding the importance of asset allocation for the performance of diversified portfolios are:

      1. How much of the variability of returns across time is explained by the asset allocation framework set forth in the investment policy? That is, how many of a fund's ups and downs are explained by its policy benchmarks? The impact of asset allocation on time variation was studied in BHB. Since then, a number of studies have reexamined this question (Ibbotson and Kaplan 2000). These studies generally agree that a high degree (85 % to 90 %) of the time variation in diversified portfolios of traditional assets is explained by the overall asset allocation decisions of asset owners and portfolio managers. Therefore, if an asset allocator wants to evaluate the expected volatility of two diversified portfolios, then the asset allocation policies of the two funds will be very informative.

      2. How much of the difference in the average returns among funds is explained by differences in the investment policy? That is, if the average returns of two diversified funds are compared, how much of the difference in relative performance can be explained by differences in asset allocation policies? The answer depends greatly on the sample, but most studies show that less than 50 % of the difference in average returns can be explained by differences in asset allocation. Other factors – such as asset class timing, style within asset classes, security selection, and fees – explain the remaining differences. Therefore, if an asset allocator wants to evaluate the expected returns of two diversified funds, asset allocation policies of the two funds will be useful, but other factors should be taken into account.

      3. What portion of the average return of a fund is explained by its asset allocation policy? In this case, we are considering the absolute performance of a fund. That is, suppose the realized average return on a fund is compared with the return on the fund if the manager had implemented the proposed asset allocation using passive benchmarks. How do these two performances compare? Does the manager outperform the passive implementation of the asset allocation policy? This appears to be the most relevant question, because it directly tests the active management of the portfolio. It turns out that this is the most difficult question to answer, and the available results are highly dependent on the sample and the period they cover. Most studies find that asset allocation has little explanatory power in predicting whether a manager will outperform or underperform the asset allocation return. In fact, available studies covering samples of mutual funds and pension funds conclude that 65 % to 85 % of them underperform the long-run asset allocation described in their investment policy statements or their passive benchmarks (Ibbotson and Kaplan 2000)1.

      Given the importance of asset allocation, the rest of this chapter focuses on the asset allocation process, the role of asset owners in determining the objectives and constraints of the process, and the difference between strategic and tactical asset allocation programs.

      1.2 The Five Steps of the Asset Allocation Process

      This section describes the typical steps that must be taken to implement a systematic asset allocation program.2 A systematic approach enables the asset allocator to design and implement an investment strategy for the sole benefit of the asset owners. Such an approach needs to focus on the objectives and the constraints that are relevant to the asset owner. We begin with a discussion of the first of the five steps in the asset allocation process: identifying the asset owners and their potential objectives and constraints. In most cases, assets are managed to fund potential liabilities. In some instances, these liabilities represent legal obligations of the asset owner, such as the assets of a defined benefit (DB) pension fund. In other cases, assets are not meant to fund legal obligations but to fund essential needs of the asset owners or their beneficiaries. For example, a foundation's assets are managed to fund its future philanthropic and grant-giving activities. The nature of these potential needs or liabilities is a major determinant of the objectives and constraints of each asset owner.

      The second step involves developing an overall approach to asset allocation. A critical step is preparing the investment policy statement. The investment policy statement includes the asset allocator's understanding of the objectives and constraints of the asset owners, the menu of asset classes to be considered, whether active or passive approaches will be used, and how often and under what circumstances the allocation will be changed. Such changes arise because of fundamental changes in economic conditions or changes in the circumstances of the asset owner.

      The third step is implementing the overall asset allocation

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