Determinants of Portfolio Returns – It Depends…

January 24, 2025 |
2 minute read
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Determinants of Portfolio Returns – It Depends…
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Asset allocation decisions have traditionally been associated with being the major determinant of portfolio returns. The Brinson, Hood, Beebower study of 19861 estimated that nearly 90 percent of portfolio return variation is driven by asset allocation.

While subsequent research challenged this notion, most of this research evaluated liquid assets, such as stocks and bonds, and did not consider the impact of private strategies. Here we will create a simple framework to evaluate the impact from asset allocation versus manager selection using different portfolio implementations.  

For definitional purposes:

Asset Allocation is defined as the return associated with the market return for public asset classes and the median return for private strategies.

Manager Selection is defined as the return associated with all investment decisions other than asset allocation including portfolio construction, manager selection, tactical allocation or thematic investing and security selection.

Portfolio 1 – Index Portfolio (100% return from Asset Allocation)

An indexed portfolio of 70% equities and 30% bonds utilizing a passive approach derives all its return from asset allocation. This makes sense since there are no active manager selection decisions.

Portfolio 2 – Traditional Active Portfolio (80%-90% return from Asset Allocation)

If active managers (i.e., active risk) are added to a traditional portfolio, almost 90% of the returns come from asset allocation consistent with the basic conclusion of the Brinson, Hood, Beebower study in 1986.

Traditional Portfolio Portfolio Asset Allocation Underperforming Active Return Passive
Return
Outperforming Active Return
Equity 70% 7.0% 8.0% 9.0%
Fixed 30% 3.5% 4.0% 4.5%
Portfolio Return   6.0% 6.8% 7.7%
Percent Return from Asset Allocation   88% 100% 89%
Percent Return from Manager Selection   13% 0% 11%
Note: The passive 8 percent equity market return and 4 percent fixed income return are approximations of historical returns and return premia. A small level of active risk is assumed relative to the respective benchmarks of 1 percent and 50 basis points respectively.

Portfolio 3 – Endowment Portfolio (40%-60% return from Asset Allocation)

If illiquid private investment strategies are included, as is often this case for an endowment style investing framework, the investor experiences a greater degree of dispersion in portfolio outcomes. This is driven by the much wider manager dispersion historically experienced in private strategies as seen below.

  Global Public Equity Managers All Privates Funds
Top Quartile 10.4% 16.4%
Median 9.4% 8.6%
Bottom Quartile 7.7% 1.0%

Source: 10 Year returns ending 9/30/24 Global Equity Managers Evestment. All private funds ending 9/30/24 Burgiss Database.

 

Endowment Portfolio Portfolio Asset Allocation Underperforming Active Return Passive
Return
Outperforming Active Return
Equity 35% 6.0% 8.0% 10.0%
Fixed 15% 3.5% 4.0% 4.5%
Alternatives 50% 1.0% 8.0% 15.0%
Portfolio Return   3.1% 7.4% 11.7%
Percent Return from Asset Allocation   42% 100% 63%
Percent Return from Manager Selection   58% 0% 37%

Note: A higher level of active risk is assumed relative to equities of 2 percent. Alternatives return assumption is 8 percent which approximates the median return for all private investments in Burgiss Database. Further, the 7 percent return spread around the median approximates the historical return spread in the Burgiss Database.

Asset allocation is still a major driver of total returns, but as active risk and illiquidity increases, manager selection becomes a larger driver of portfolio performance. Most institutional portfolios sit somewhere along the spectrum of the portfolios presented above. The below chart highlights a simple framework when thinking about what determines portfolio returns.

CHT-Determinants-of-Portfolio-Returns-updatedIn conclusion, the investors approach to portfolio execution determines the degree of impact from asset allocation or manager selection. The greater the degree of active risk taken, combined with higher manager dispersion within certain asset classes, increases the returns associated with manager selection. Most investors intuitively understand this dynamic, and it is likely a major driver of the Outsourced CIO model over the traditional investment committee approach. While asset allocation still drives a majority of return outcomes, manager selection has become a greater determinant of portfolio return over time due to higher active risk budgets and the increased adoption of private strategies.

  1. Source: Financial Analysts Journal, Vol. 42, No. 4 (Brinson Et Al. (1986) - Determinants of Portfolio Performance | PDF | Active Management | Asset Allocation)
Paul Von Steenburg

Author

Paul Von Steenburg

Managing Director

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Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

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Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.