It’s a question that comes up time and time again. Which has more impact on an investor’s returns - choice of index or choice of fund?
There are no simple answers. It’s a complicated and controversial subject and you could spend a lifetime trying to make sense of conflicting research. And while top level asset allocation and security selection evidently do different jobs, we think there’s a strong argument that asset allocating at the index level can have a bigger overall impact on an investor’s risk-adjusted returns.
One study suggests that factors like individual stock selection and market timing made up less than 7% of a diversified portfolio’s return - in other words, asset allocation contributed the large majority. Another study of pension plan managers states that 91.5% of the divergence between the performance of two portfolios was explained by asset allocation.
While these figures might be considered extreme, their general finding is supported by a study from prominent financial thinkers Brinson, Singer and Beebower. They also based their argument on the idea that the main part of a portfolio’s return comes from asset allocation. Like many portfolio theories, their research is not without opposition. But our view is that their conclusions still stack up.
One main critique of Brinson and Co’s study is that they focus on the volatility of returns. But if we think about risk-adjusted returns, then it’s the benefits of the diversification that asset allocation offers which remains the key point here.
Another issue is that the studies of Brinson and Co were conducted over a limited ten year period in the mid-1970s, which arguably doesn’t represent the whole spectrum of market conditions. Interestingly though, The University of Cambridge’s Judge Business School conducted a similar study over twenty years, which captured the tumultuous dot com bubble and the more recent financial crisis. These results cover a more diverse range of market environments, giving us a much wider view of the impact of asset allocation on returns.
It’s interesting but unsurprising that stock selection during the dot-com era was a bigger driver. Overall though, the results led to the strong conclusion that asset allocation is more important than security selection, especially in times of greater market volatility.
What’s more, in a report entitled Asset Allocation vs. Security Selection, the CFA conclude that “On the basis of a correlation analysis, we found that two-thirds of variation is due to asset allocation and one-third to security selection.” A compelling argument when, as they go on to point out, you consider the costs of investigating 40 equity and bond markets versus the costs of investigating 4,000 individual securities.
According to the CFA, their report demonstrates the importance of two things to investors:
So, despite the controversy around the subject, one thing is clear - asset allocation is extremely important. An investor’s choice of different indices can have a far bigger impact on their risk-adjusted returns than individual fund choice. This is because the right mix of asset classes offers crucial diversification across a variety of market conditions, and reducing correlations between asset classes ultimately helps drive an investor’s risk-adjusted returns.
Index investing is what we do. We take the hassle out of investing by using a client’s objectives to automate asset allocation, using the far more cost-effective Exchange Traded Funds. Not only does our technology help our clients decide the right combination of indices – we’ll also select the most appropriate instrument to replicate these indices. And that means no more soul-destroying Sunday afternoons with your head buried in spreadsheets.