Numerous academic studies have argued that asset allocation is the biggest determinant of long-term investment performance, but investors have been cautioned against thinking this means fund selection can be thrown out of the window. 
Determinants of Portfolio Performance, a paper published in 1986 by Gary P Brinson, L Randolph Hood and Gilbert L Beebower, concluded that more than 90 per cent of a portfolio’s variance of returns can be attributed to asset allocation, not the active return created through security selection and timing.
This led to many investors thinking that asset allocation should be the main focus of their efforts, with fund selection relegated to something that can safely be a second hand concern. Indeed, this argument has also been used to suggest investors should only hold passive funds, rather than risk using an active manager.
However, not all agree that most of a portfolio’s performance is down to asset allocation and some point out that Determinants of Portfolio Performance has been inaccurately used by passive groups as a marketing tool. Even one of its authors said the research was not carried out as an attack on active management.
A 2010 paper by Roger G Ibbotson, James Xiong, Tom Idzorek and Peng Chen also highlighted a number of flaws with the original study and concluded that “active management has about the same impact on performance as a fund’s specific asset allocation policy”.
Ibbotson added: “The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 per cent of the variation in returns is caused by the specific asset allocation mix.”
A quick look at the various sectors in the Investment Association universe shows how picking the right or wrong fund can have a drastic impact on the ultimate outcome of a portfolio.
Since 1 January 2000, IA China/Greater China has been the best performing sector with a 271.15 per cent average total return. However, the highest returning fund has made 491.03 per cent while worse is up just 56.11 per cent.
As the graph below shows, the difference in returns is even starker in the second best performing sector – IA UK Smaller Companies. The average return here since the start of the millennium has been 219.83 per cent but Marlborough Special Situations has made 712.25 per cent while Henderson UK Smaller Companies managed 48.47 per cent.
Performance funds and sector since 1 Jan 2000
Source: FE Analytics
Simon Evan-Cook (pictured on previous page), senior investment manager for multi-asset funds at Premier, uses both asset allocation and bottom-up fund selection when building portfolios, but said: “Both are very important, but I do get the sense that many underestimate just how important fund selection can be.”
“It’s great when our ‘big ideas’ pay off. But by their nature, there are fewer of these in any fund we run and they can sometimes take years to start working as timing them perfectly is nigh-on impossible,” he added
“So while we’re waiting for these to work, our highly active fund holdings give us hundreds of ‘small ideas’ that are working for us on a daily basis. Effectively, just like dividends, they pay us to wait.”
The manager gives an example of how a ‘big idea’ asset allocation call can sit alongside prudent fund selection by using the Premier Multi-Asset Global Growth fund. When the team took over the portfolio in June 2012, it chose to go significantly underweight US equities in preference of Asian equities.
“As an asset allocation idea it hasn’t worked yet, as US equities have made 64 per cent in that time, whereas Asian equities have made just 18 per cent,” Evan-Cook said.
“But one of our core Asian holdings has been Prusik Asian Equity Income, which made 75 per cent over the same period. So we have not suffered unduly in that time and still feel comfortable holding our US and Asian positions because we aren’t facing the pressure that comes from underperformance. In fact, we’re excited about what will happen when that ‘big idea’ pays off.”
Performance funds vs sectors and indices since 29 Jun 2012
Source: FE Analytics
Adrian Lowcock, head of investing at AXA Wealth, agrees that asset allocation is an important part of portfolio construction but stresses that it should not come at the expense of fund selection.
He cites three main reasons why fund selection should be at the forefront of investors’ minds: performance, as a good active manager can add value “above and beyond” the asset class return; valuations, as active managers are able to buy cheap stocks while trackers have to own everything in the index not matter how expensive; and avoiding poorly managed businesses, as active funds can focus on companies with strong management.
But Lowcock says investors have to keep some key points in mind when buying a fund.
“Make sure the fund manager is adding value,” he said. “For example, some mid-cap funds have boosted their performance by investing in smaller companies when they are doing well. This might make the fund look better but is the manager adding value by asset allocating to smaller companies or through stock selection?”
“It is important to identify what is driving the performance. Is it stock picking ability or is it allocation to an index? Good managers have exceptional stock picking ability.”
Other attributes to watch for include conviction, as good managers will have the confidence to do something different from the market and ride through the tough times, and a robust process, which can hint that they can deliver repeatable performance over the long term.
“Ultimately an investor can benefit from asset allocation but fund selection will give you the cherry and icing on top,” Lowcock added.
“If you buy an asset allocation-only approach then you are willing to give up an additional boost to performance and personally I look for all the help I can get to improve the returns of my investments.”
In a coming article, FE Trustnet will highlight the sectors where fund selection would have made a big difference over recent years.
