Asset Allocation and Its Contribution to Returns: Evidence From International Markets


Numerous studies on the performance of diversified U.S. equity portfolios have demonstrated the central role that asset allocation policy plays in determining variation of portfolio returns. Likewise, reams of academic research have shown, in stark terms, the damaging effects of the higher costs associated with active management. Some have argued that these outcomes are the result of the high efficiency of the U.S. equity markets. There is an oft-heard claim that international markets are not as efficient as domestic markets, so market timing and stock selection are more likely to add value.

A study by Wolfgang Drobetz and Friederike Kohler, "The Contribution of Asset Allocation Policy to Portfolio Performance," examined the performance of fifty-one German and Swiss balanced mutual funds in order to determine what portion of the performance of a fund can be attributed to policy (asset allocation), and what portion to market timing and stock selection.(1) The study required that funds have at least six years of monthly data, with the sample period ending July 31, 2001.
The study concluded that:

  • Over 80 percent of the variability of returns of a typical fund over time is explained by asset allocation policy.
  • Roughly 60 percent of the variation among funds is explained by policy.
  • Over 130 percent of the return level (what investors ultimately care about) is explained, on average, by the policy return level (asset allocation).
  • Actively managed German and Swiss mutual funds produced alphas (the return not attributed to policy - see glossary of this site) of negative 2.4 percent per annum.
The authors concluded that German and Swiss active managers were not only unable to add value (produce a positive alpha) by deviating from their benchmarks, but their market timing and stock selection decisions were destroying the financial wealth of their investors. What is also of interest is that when ranked by performance, even the top 5 percent of funds destroyed about 1 percent of the return policy alone would have contributed. The median firm destroyed about 24 percent of the returns explained by policy. The bottom 5 percent destroyed over 44 percent of the policy returns. The authors stated that these dismal results could be partially, but not fully, explained by the relatively higher (compared to U.S. mutual funds) expense ratios. The greater trading costs incurred in international markets (another hurdle active managers must overcome in order to add value) almost certainly accounts for a significant portion of the negative alphas.

This study adds to the substantial body of work that has demonstrated that active management is highly likely to be counterproductive over time, regardless of whether the equity market is domestic, international, or even emerging.