Global Case For Strategic Asset Allocation And An Examination Of Home Bias by Brian J. Scott, CFA; James Balsamo; Kelly N. McShane; Christos Tasopoulos – Vanguard

  • Broadly diversified balanced funds with limited market timing tend, over time, to move in tandem with overall financial markets. Our empirical analysis, as well as that originally performed by Brinson, Hood, and Beebower (1986), illustrates the significance of a broadly diversified asset allocation.
  • Active management has produced significant performance dispersion across portfolios. Our analysis, based on work first published by Jahnke (1997), also supports the possibility of outperformance based on an investor’s selecting a “winning” actively managed fund. We found, on average, that active management reduces a portfolio’s returns and increases its volatility compared with a passive index-based implementation of the portfolio’s asset allocation policy. At the same time, our findings support the view that active management can create an opportunity for a portfolio to outperform.
  • As a result, when building portfolios, market-capitalization-weighted global indexes are a valuable starting point for all investors. Yet we find that many investors tilt their portfolios away from market cap, either consciously or unconsciously. Perhaps the most prominent tilt investors make is toward a home bias. To the extent this is an unconscious choice, we provide a framework for considering the benefits of global diversification.

The seminal 1986 paper by Brinson, Hood, and Beebower (henceforth BHB), “Determinants of Portfolio Performance,” concluded that asset allocation is the primary driver of a portfolio’s return variability for broadly diversified portfolios. Yet disagreements or misunderstandings about the findings’ relevance to investors still make the topic valuable to clarify for investors.

We examine two key questions: How does asset allocation affect your risk/return expectation? And how much home bias is reasonable? We analyze these questions in five major markets: the United States, Canada, the United Kingdom, Australia, and Japan. We briefly review two studies at the core of this debate: BHB’s paper and Jahnke’s “The Asset Allocation Hoax” (1997). We then expand upon Vanguard’s past research, most notably The Global Case for Strategic Asset Allocation by Wallick et al. (2012). Finally, we discuss the role of home bias tilts in relation to asset allocation.

The ongoing asset allocation debate

In their landmark paper, BHB concluded that a portfolio’s static target asset allocation explained the majority of a broadly diversified portfolio’s return variability over time. These findings were confirmed by Vanguard and other research, including Ibbotson and Kaplan (2000), suggesting that a portfolio’s investment policy is an important contributor to return variability (Hood, 2005). Investment advisors have generally interpreted this research to mean that selecting an appropriate asset allocation is more important than selecting the funds used to implement it. Vanguard’s findings indicate that both are important, yet we suggest the following sequence for portfolio construction: Start with an asset allocation policy decision, then consider the implementation strategy.

In 1997, Jahnke argued that BHB’s focus on explaining return variability over time ignored the wide dispersion of returns among broadly diversified active balanced funds over a specific time horizon. In other words, he maintained that a portfolio could achieve very different terminal wealth levels, depending on which (active) funds were selected. Jahnke’s analysis emphasized that, as a result of active management strategies, actual returns earned should be examined across different active balanced funds within a set holding period. It is correct that the BHB study did not show that two funds with the same asset allocation can have very different holding-period returns. The research we report here confirms the findings of both studies and views them as separate analyses that ultimately helped us address this question: Can active management increase a portfolio’s returns without increasing the volatility experienced?

Our analytical framework

Vanguard’s latest research updates analysis from 2012. It covers the United States, Canada, the United Kingdom, Australia, and Japan from January 1990 to September 2015. Previous versions of this research analyzed a longer data history, but the current analysis was shortened to cover a common time period and include additional markets. This research confirms our earlier conclusions that, over time and on average, most of the return variability of a broadly diversified portfolio that engages in limited market timing is due to its underlying static asset allocation. Active investment decisions such as market timing and security selection had relatively little impact on return variability over time.

To determine the relative performance of asset allocation and active management, we needed to distinguish between a portfolio’s policy return (or asset allocation return)—that is, what a portfolio could have earned if it recreated its policy allocation with passively managed index funds—and the actual return earned by the active balanced fund over the period. Our empirical case tested BHB’s and Jahnke’s studies on a global scale, using a greater number of balanced mutual funds.1

Time-series regression (per BHB, 1986)

Return variability measures the extent to which actual returns diverge from the policy returns. Therefore, greater variability in returns would suggest a wider possibility of returns and a lessened ability to predict results, inherently indicating increased portfolio volatility. The variation in the policy return that explains the percentage of variations in the actual return is measured by the adjusted R-squared (R2) derived from a time-series regression analysis of the fund’s actual return versus its policy return. A high adjusted R2 would mean that variations in the policy return explained a high percentage of the variation in fund returns.

BHB’s 1986 conclusions were derived from the results of a time-series analysis measuring the effect of asset allocation on return variability. Such an analysis compares the performance of a policy (long-term) asset allocation represented by market indexes with the actual performance of a portfolio over time. Our results confirmed BHB’s findings that, on average and over time, most of the return variability of a broadly diversified portfolio that engages in limited market timing was attributable to the ups and downs of its policy asset allocation. Active investment decisions—such as market timing and security selection—had relatively little impact on return variability over time.

It is important to acknowledge that BHB’s data set was pension funds, which were typically exposed to a high level of systematic market risk, resulting in high R2 numbers versus the returns of their policy portfolios over time. BHB’s analysis concluded that more than 90% of return variability over time could be explained by the asset allocation policy. Ibbotson and Kaplan (2000) and Vanguard research found similar results for the balanced mutual fund universes in the United States, Canada, the United Kingdom, Australia, and Japan, with percentages slightly lower than BHB’s findings (see Figure 1).

As the figure shows, asset allocation largely contributed to return variability over time. As a result, asset allocation is key in managing the range, or variability (experienced volatility), of a portfolio’s returns over time.

Home Bias

Cross-sectional regression (per Jahnke, 1997)

The adjusted R2 derived from a cross-sectional regression analysis of the fund’s actual return versus its policy return is used to measure the degree to which an asset allocation (passive) policy compared with an active management strategy and explains the dispersion of returns across funds over a set time horizon.

In considering Jahnke’s emphasis on determining how much asset allocation affects actual portfolio return dispersion across funds, we

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