1986 Study Reveals What Determines Portfolio Returns

13.09.2016 • Central Banks

From Capital & Conflict (Great Britain) –

All hat and no cattle. That’s what Janet Yellen and her crew at the Fed are now. They’re all talk. No action. The evidence is in Monday’s rally in US stocks after Fed member Lael Brainard gave comments that only a dove could love.

The focus here in the UK now shifts to the Bank of England. If the Fed won’t raise rates, will the Bank of England do any more stimulating? Or is the bank content to sit back and watch the post-Brexit British economy shimmer like a jewel off the coast of the continent?

You can tell I’m full of more questions than claims or answers today. And just to be clear, I’m not literally back at a ranch. What I’m describing is the useful exercise of retreating to whatever high and dry place you can find. Those places give you the chance to sit back, quiet your mind, and reassess your situation without constant interruptions and stimulation from the digital world.

Right now I’m discussing with Charlie Morris and Tim Price how important asset allocation and active portfolio management are. As an internal training exercise, I’ve forced some of our newer hires and compliance team to freshen up on some of the seminal literature in the investment industry. This week it was the 1986 classic Determinants of Portfolio Performance, otherwise known as the Brinson study.

The study has been widely (and deliberately) misquoted since it was first published. The version you may have heard is that over 90% of the total return in your portfolio comes from the asset allocation strategy you adopt. This makes other factors – stock selection, market timing, fees – less important. If it’s a bull market in stocks, buy stocks. You should do fine. And it will be hard for active management to do much better.

Mind you, you still have to have an asset allocation strategy. That’s the correct mix between stocks, bonds, property, precious metals, and cash (assuming you’re still allowed to own it in the future). But with all the focus on the correct asset allocation, people seem to have forgotten that the study didn’t actually say that more than 90% of your portfolio returns come from the right mix.

The Brinson study concluded that 93.6% of the variation in an average fund’s returns comes from asset allocation. There’s a big difference between the variation in your returns and your total returns. I’ll go into it more tomorrow.

But I brought up the subject with Charlie on the phone. He’s putting the latest monthly edition of The Fleet Street Letter to bed. Charlie finds himself in the unique position of recommending both technology stocks (on a growth basis) and bank stocks (on a value basis) when many others say the market is overvalued and the economy is on the verge of a recession.

I’m not sure you could find a British analyst whose more bullish on UK stocks, believes that rates will rise because growth is rising, and ditched bonds long ago because low-risk fixed income strategies won’t do well when rates rise.

“Is the Brinson study right Charlie?” I asked.

“There are a lot of factors to these studies,” he said.

“That sounds like a dodge,” I replied.

“Not at all. It’s like this. Asset allocation [Brinson] helps get your boat in the right pond. That pond is full of fish. That means when you take more risk, you should get better returns. That’s what happens in a normal world.”

“But it’s not a normal world.”

“Correct. It’s all one big pond. And that’s because of low interest rates. Low-risk and high-risk strategies have generated the same returns because of lower rates. Investors in higher-risk strategies haven’t been compensated for it. And investors in lower-risk strategies have been over-compensated for it.”

“What does that have to do with fish?”

“In a normal market, asset allocation only puts you in the right pond where all the fish are. To catch them is stock selection. The right bait. The right lures. That’s when you have to start talking about other factors.”

“Which ones?” I asked.

“To use one of your phrases Daniel, that’s beyond the scope of today’s phone conversation.”

And so it was.

-Read more at CapitalandConflict.com (English)-

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