The ability to pick the best securities in a specific market is much less important than your choice of which markets to invest in.

Consider the example of emerging market equities, which underperformed U.S. equities by more than 55% over the five years through November 2015. Developed international markets also lagged U.S. stocks by a substantial margin.

The Vanguard FTSE Developed Markets ETF (ex-U.S.) generated just 20% total return, or 3.7% per year, lagging U.S. stocks by 8.4% annualized, according to data from Commodity Systems Inc. Now, consider that the Vanguard Total Stock Market ETF (which tracks the CRSP US Total Market Index) produced more than 14% per year over the past five years.

What’s the likelihood that an investor—even a great investor—who chose stocks from non-U.S. markets over the past five years was able to outperform even a poorly skilled manager selecting from U.S. stocks (see Chart 1)?

To get a sense of stock picking’s impact in individual markets, let’s examine the range of mutual fund outcomes for funds focused on each region (see Table 1). According to Reuters’ fund screener, a 95th-percentile U.S. equity fund delivered 15.5% annualized over the period, while a fifth-percentile fund was 8.8%.

Meanwhile, active international equity mutual funds’ performance ranged from 5.7% to -1.7%. Incredibly, a 95th-percentile manager in emerging markets equities delivered just 1.7% annualized over the past five years, while a fifth-percentile fund lost more than 7% per year (see Table 1).

Table 1: Performance range of active mutual funds over five years

Ending December 31, 2015

Market 95th percentile Index 5th percentile
U.S. stocks 15.5% 13.9% 8.8%
Int’l developed stocks 5.7% 4.3% -1.7%
Emerging stocks 1.7% -4.0% -7.0%

Data source: Reuters

So, while most investors try to pick the best stocks (or the best stock-pickers), these decisions actually mean very little compared to decisions about asset allocation. At the best of times, asset allocation and stock-picking have about the same influence on portfolio outcomes; at the worst of times, asset allocation almost completely determines success or failure. Yet, most investors embrace policy portfolios that explicitly limit deviations from strategic, long-term asset allocation targets.

They’re approaching the problem backwards.

Key questions

Most previous studies on asset allocation impact relative to security selection have been performed on pension funds and mutual funds, and explore the degree to which total portfolio variance is explained by deviations from institutions’ long-term policy portfolios.

The studies are structured as attribution analyses, where portfolio returns are disaggregated into returns due to the policy portfolio and active returns, which in most studies are defined as the residual not accounted for by the policy portfolio.

In 1986, and again in 1991, Brinson et al. regressed monthly portfolio total returns for pension funds against the monthly returns to each fund’s policy portfolio, and determined that the policy portfolio explains approximately 90% of the monthly variance in total returns. Many citations of Brinson’s original publications in this field falsely suggest the analysis makes conclusions about long-term performance attribution. However, Brinson’s seminal studies mainly proved that once institutions set a strategic asset allocation, they tend to stick to it with minimal deviation through time.

Ibbotson and Kaplan recognized the universal misperception around Brinson’s analyses and set out to correct it. In their paper “Does asset allocation explain 40, 90, or 100 percent of performance?” (Financial Analysts Journal, January/February 2000, vol. 56 issue 1), they address the confusion by attempting to answer three questions:

  1. How much of a fund’s ups and downs do its policy benchmarks explain?
  2. How much of the difference between two funds’ performance is a result of their policy differences?
  3. What portion of the return level is explained by policy return?

Ibbotson and Kaplan analyzed mutual fund data for 10 years through March 31, 1998, and pension data from 1993 to 1997.

Table 2: Comparison of time-series regression studies (extending Brinson et al.)

Measure R2 Brinson 1986 Brinson 1991 Mutual Funds Pension Funds
Mean 93.6% 91.5% 81.4% 88.0%
Median NA NA 87.6% 90.7%
Active Return Brinson 1986 Brinson 1991 Mutual Funds Pension Funds
Mean -1.10 -0.08 -0.27 -0.44
Median NA NA 0.00 0.18

NA = not available. Active return is expressed as a percentage per year. Source: Ibbotson & Kaplan (2000)

Explaining variability of returns

To answer the first question, Ibbotson and Kaplan repeated the analysis from Brinson et al. and confirmed their results showing that policy weights explain 88% of fund returns. Ibbotson and Kaplan also provided intercept values from time-series regressions corresponding to annualized excess returns to the funds over the policy portfolios. On average, excess returns were negative, but not significantly so (see Table 2).

Importantly, Ibbotson and Kaplan show fund returns are mostly attributable to investing in capital markets in general, not from the specific asset allocation policies of each fund. Regressions on the market, represented by the average policy portfolio, almost completely subsumed regressions on individual policy portfolios, explaining up to 79% of the 81% of returns represented by individual policy portfolios themselves.

In fact, 75% of fund returns were explained by U.S. equity returns alone. (Note: they analyzed balanced funds only, not pension funds). As a result, Ibbotson and Kaplan concluded that “the results of the Brinson et al. studies and our own results […] are a case of a rising tide lifting all boats” (see Table 3).

Table 3: Explaining mutual funds’ time-series of returns using different market portfolios

R2 S&P500 Average Policy Fund’s Policy
Mean 75.2% 78.8% 81.4%
Median 81.9% 85.2% 87.6%

Source: Ibbotson & Kaplan (2000)

If you accept that market returns are a common variable and should thus be removed from the attribution analysis, then what portion of residual returns are explained by differences in policy weights versus active management? This question is answered, at least for U.S. mutual funds, in a 2010 paper titled “The equal importance of asset allocation and active management,” by James X. Xiong et al. (Financial Analysts Journal, March/April 2010, vol. 66, issue 2).

Table 4, shows that once common market movement is removed, asset allocation policy and active management explain approximately the same amount of total returns—about 20% each—across the different fund categories. However, the asset allocation policy for balanced funds, which mix bonds and stocks, explains about twice as much variance as active management.

Table 4: Decomposition of time-series total return variations in terms of average R2s

May 1999 to April 2009

Average R2 U.S. Equity Funds Balanced Funds Int’l
Market movement 83% 88% 74%
Asset allocation policy 18% 20% 19%
Active management 15% 10% 26%
Interaction effect -16% -18% -19%
Total 100% 100% 100%

Source: “The equal importance of asset allocation and active management” by James X. Xiong, Roger G. Ibbotson, Thomas M. Idzorek, and Peng Chen (2010).

Interestingly, active management was more influential for international funds, probably reflecting time-varying exposures to various non-U.S. equity markets.

How much do policy differences explain?

On average, market exposures and asset allocation policy explain about 90% of total returns, while active management explains just 10%. However, this doesn’t answer the questions on most investors’ minds—the second and third questions Ibbotson and Kaplan pose.

Ibbotson and Kaplan’s answer to the second question is problematic because their analysis did not control for the impact of the market factor. Xiong et al. correct for this in their paper by performing both time-series and cross-sectional regressions on excess returns, which remove the impact of market returns.

Table 5, this page, shows asset allocation policy and active management are equally important in explaining the variation in returns across funds. Again, the active management portion includes both time-varying (tactical) exposures to market variables as well as individual security bets, so some portion of the active variable is also attributable to asset allocation.

Table 5: Decomposition of time-series excess market return variations in terms of R2 average

May 1999 to April 2009

Average R2 U.S. Equity Funds Balanced Funds Int’l
Asset allocation 48% 36% 49%
Active management 41% 39% 45%
Interaction effect 11% 25% 6%
Total 100% 100% 100%

Source: “The equal importance of asset allocation and active management” by James X. Xiong, Roger G. Ibbotson, Thomas M. Idzorek, and Peng Chen (2010).

What portion of the return level is explained by policy return?

Lastly, Ibbotson and Kaplan set out to capture the percentage of total returns to institutions that is explained by asset allocation policy versus active management. The math for this step is simple: it’s the ratio of compound annual return experienced by the passive policy portfolio divided by the compound annual return experienced by the fund itself. (The difference between policy returns and fund returns is driven by tactical asset allocation, manager selection, security selection, fees and expenses.) Table 6 suggests that a simple passive investment in the policy portfolio would have delivered equal or better results on average than engaging in active management.

Ibbotson and Kaplan stated that, on average, asset allocation explained 99% and 104% of long-term returns for pensions and mutual funds, respectively. How might we interpret this finding? Recall that the total return to portfolios was broken down into the total return to the fund’s policy portfolio using asset class benchmarks, plus the active return, minus trading costs. So, the results of this study demonstrate that, over the periods studied, the average institution lost 4% of total return to fees, ineffective active management or poor manager selection.

Table 6: Percentage of total return level explained by policy return

Study Average
Brinson 1986 112
Brinson 1991 101
Ibbotson 2000 [Mutual Funds] 104 100
Ibbotson 2000 [Pension Funds] 99 99

Source: Ibbotson and Kaplan (2000)

Combined with the original analysis by Brinson, which shows institutions make few material deviations from policy weights, we’re left to conclude that the vast majority of the dispersion and performance decay observed by Ibbotson and Kaplan was due to fees and poor active security selection.


Most investors focus on security selection rather than asset allocation to produce better portfolio outcomes. The evidence shows this approach is misguided. The opportunity to produce differentiated performance is much greater from active asset allocation than from active security selection.

CHART 1: Performance over five years ending November 29, 2015

by Adam Butler, CFA, CAIA, chief executive officer of ReSolve Asset Management.