This post is to be read in conjunction with General Advice Warning detailed at the end of this post.
Introduction:
What drives returns? What are the ‘levers’ we might look to pull in order to try and generate a return for our portfolio?
Researchers Xiong, Ibbotson, Idzorek and Chen1 looked at this very question. They wanted to analyse and dig into fund returns to try and understand what were the levers being pulled and what impact did they have on returns. What they were keen to answer was:
“What are the factors that drive returns for a portfolio and of those factors, which do the ‘heavy lifting’?
They analysed the returns of 5,681 funds between May 1999 – April 2009 and found that there were 3 main factors that drove returns:
- The underlying market itself
- The asset allocation approach the fund took to the particular market
- Active management the fund employed; timing and selection.
What the researchers found in their analysis was roughly 80% of the average fund return was driven by the underlying market itself. The other two factors – asset allocation and active management drove the balance in approximately 50/50 split of contribution.
What does this mean?
Put simply, being exposed to a market for a portfolio is by far the biggest factor in determining its returns. Far more so than the influence active management provides.
In the analogy of the ‘glass jar, rocks, pebbles and sand’; just ‘owning’ a part of a market is the big rock. Active management / timing / selection is at best a ‘pebble’ and when viewed in aggregate, more akin to ‘sand’ in the overall return ‘jar’.
To be fair – there are undoubtedly some fund managers whose active management may add a considerable positive return to the overall performance and return of the fund.
The practical challenge is twofold:
- The active management component has been shown to be a minor contributing factor in influencing average fund returns.
- Not withstanding active management on average is a minor contributing factor, finding ahead of time an enduring fund manager who can outperform is a significant challenge in and of itself with ~85% of fund managers failing to beat their benchmark over a 15 year period.
One of the risks with pursing an active management strategy is that in a market environment, there are no ‘participation trophies’ for performance. By definition, not all active fund managers can outperform because they are, in aggregate, the market. Some will outperform and some will underperform. By opting for an active management strategy, an investor must understand they are exposing their portfolio to the potential of both.
Bottom line:
There are some fund managers out there who have superior skill and capacity to add significant value through their active work of moving in and out of the market and favouring certains shares over others. The practical challenge is a. this skill on average doesn’t give you your biggest bang for your buck, and b. finding the managers who can actually do it ahead of time is very, very difficult to do.
Reference:
1. Xiong, J. X. et al. (2010) ‘The Equal Importance of Asset Allocation and Active Management’, Financial Analysts Journal, 66(2), pp. 1–9. doi: 10.2469/faj.v66.n2.7
General Advice Warning
This post, the research, ideas, theories and conclusions presented in it are for general advice and / or informational purposes only. Your personal circumstances, situation or objectives have not been taken into account when preparing it.
No person should make a decision regarding their investments, superannuation or insurance polices based on this information alone. You should before making any decision with respect to your investments, superannuation or insurance policies consult with a financial adviser to determine if the decision is an appropriate one for you, your objectives, personal situation and needs.
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