Does Asset Allocation Policy Explain 40, 90, 100 Percent of Performance?

Does asset allocation policy explain 40 percent, 90 percent, or 100 percent of performance? According to some well-known studies, more than 90 percent of the variability of a typical plan sponsor's performance over time is attributable to asset allocation. However, few people want to explain variability over time. Instead, an analyst might want to know how important it is in explaining the differences in return from one fund to another, or what percentage of the level of a typical fund's return is the result of asset allocation. To address these aspects of the role of asset allocation policy, we investigated these three questions. 1. How much of the variability of returns across time is explained by asset allocation policy? 2. How much of the variation of returns among funds is explained by differences in asset allocation policy? 3. What portion of the return level is explained by returns to asset allocation policy? We examined 10 years of monthly returns to 94 balanced mutual funds and 5 years of quarterly returns to 58 pension funds. For the mutual funds, we used return-based style analysis for the entire 120-month period to estimate policy weights for each fund. We carried out the same type of analysis on quarterly returns of 58 pension funds for the five-year 1993-97 period. For the pension funds, rather than estimated policy weights, we used the actual policy weights and asset-class benchmarks of the pension funds. We answered the three questions as follows: In summary, our analysis shows that asset allocation explains about 90 percent of the variability of a fund's returns over time but explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset allocation policy explains slightly more than 100 percent of the levels of returns. Thus, the answer to the question of whether asset allocation policy explains 40 percent, 90 percent, 100 percent of performance, depends on how the question is interpreted.