Morningstar Advisor - April/May 2010 - 31

Exhibit 3 Consistent Answers: By placing time series and cross-sectional regressions on equal footing, asset-allocation decisions in excess of market movement and active management are about equally important at explaining return variations.
Time Series and Cross-Sectional R-Squared Distributions
Frequency Excess-Market Time-Series Cross-Sectional

Long Live Asset Allocation

0.25 0.2 0.15 0.1 0.05 0%
R^2

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Exhibit 4 Market Movement Dominates: BHB attributed the bulk of total return variations to asset-allocation policy (left two bars). In contrast, HEI & IK argue that market movement dominates (right two bars).
Decomposition of Total-Return Variations
Asset-Allocation Policy Investment Strategy R-Squared Market Movement Excess-Market Asset-Allocation Policy Interaction Effect*

Investors understand that asset allocation is important, but the answer to the question of how important is tricky. Unfortunately, BHB’s landmark article unintentionally created the fallacy that 90% of return levels come from asset allocation. Investors would do well to forget the 90% number. In aggregate, 100% of return levels come from asset allocation. Return variations are dominated by the common market factor embedded in the funds being analyzed. After removing this common market factor, on average for typical funds about half of the return variations comes from detailed asset-allocation decisions in excess of the market movement and about half of the return variations comes from active management, although this 50/50 result dramatically changes from one period to the next. Our research clarifies the contribution of each and highlights the significant contribution from market movement. For aggregate return levels, asset allocation is king! K
Thomas M. Idzorek, CFA, is chief investment officer at Ibbotson Associates, a Morningstar company. References
Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio

120% 100 80 60 40 20 0 –20 BHB Equity Funds
Time-Series Regressions

Performance.” Financial Analysts Journal, July/August, pp. 39–44.
Hensel, Chris R., D. Don Ezra, and John H. Ilkiw. 1991. “The Importance of the Asset Allocation Decision.” Financial Analysts Journal, July/August, pp. 65–72. Ibbotson, Roger G., 2010. “The Importance of Asset Allocation.” Financial Analysts Journal, March/April. Ibbotson, Roger G., and Paul Kaplan, 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, January/ February, pp. 26–33.

BHB Balanced Funds

HEI & IK Equity Funds

HEI & IK Balanced Funds
Vardharaj, Raman and Frank J. Fabozzi. 2007. “Sector, Style, Region: Explaining Stock Allocation Performance,” Financial Analysts Journal, May/June, pp. 59–70. Xiong, James X., Roger G. Ibbotson, Thomas M. Idzorek, and Peng Chen, 2010. “The Equal Importance

*The interaction effect is a balancing term that makes the three return components of R-squared add up to 100%.

of Asset Allocation and Active Management,” Financial Analysts Journal, March/April.

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